European financial and economic turmoil has plagued markets for more than two years, yet officials have so far failed to find a comprehensive plan to solve the root causes of the crisis. Europe remains mired in deep recession, Greece is effectively in a depression and – despite measures announced at the June G20 meeting – the risk of Spain and Italy becoming overwhelmed by the crisis remains high.
In this environment most “safe haven” assets have performed well, with G-3 bond yields falling to all time lows earlier this year. The one stand-out exception has been gold, which has performed poorly so far this year. Gold’s poor performance in an environment of high sovereign risk has understandably caused some investors to question its historic “store of value” credentials.
In this article we look at some of the key factors that have driven the gold price in recent years, explain what has been behind the relative underperformance of the gold price so far this year, and assess the outlook and likely key catalysts for gold price performance for the rest of the year.
Since the beginning of the credit crunch in August 2007, gold has risen 140%, reaching a peak of around $1,910 an ounce on September 5, 2011. Over the period, as the financial crisis has unfolded, engulfing major financial institutions and countries, investors have sought refuge in the perceived safety of gold and its properties as an inflation, currency debasement and tail-risk hedge. However, gold has not always behaved like a safe-haven and its performance has been driven by a variety of factors, as key events have had diverse effects on investors’ behavior.
Key Events Affecting the Gold Price Over the Past 5 Years
The Beginning of the Financial Crisis
The collapse of Lehman Brothers in September 2008 sent a wave of fear around world financial markets. Most financial assets were heavily affected in the months following the announcement. Gold, after having risen 19% in the year running up to Lehman Brothers’ bankruptcy, fell by 4% in the two months leading up to the US Fed’s announcement of the first round of quantitative easing (QE1), likely as a result of general investor deleveraging.
Quantitative Easing 1 (QE1)
On November 25, 2008 the US Federal Reserve announced its first round of quantitative easing (QE1), consisting of the purchase of US$100bn of direct obligations of housing-related government-sponsored enterprises (GSEs) and US$500bn of mortgage-backed securities (MBS). On March 18, 2009, the Fed announced it was expanding its MBS program to US$1.25tn and buying up to US$300bn of longer-term Treasury securities. The bullion price surged by 36% in the four months following QE1, rising to US$1,110/oz.
The European Crisis
The European sovereign crisis kicked-off in 2010 with the first bailout to Greece on May 4, 2010. This was followed by the bailout of Ireland in November 2010, Portugal in May 2011 and eventually a restructuring of Greece’s debt in July 2011. The reaction of the gold price to these events has varied, but the general trend has been up. Although the gold price has increased by 40% over the period, most of the gains appear to have been tied to the Fed’s quantitative easing policies. As detailed later in this note, the reason behind the unusual behavior of gold can be narrowed down to its the sensitivity to both changes in the perceived outlook for the real purchasing value of the US dollar and its responsiveness to sovereign risk.
Quantitative Easing 2 (QE2)
Weakening labor market data and lower than expected growth in the US led the way to the second round of quantitative easing (QE2), announced by the Fed on November 3, 2010. The central bank committed to purchase a further US$600bn of longer-term Treasury securities by the end of the program. In this period, the gold price rose by 11% to US$1,500oz. However, the largest spike in the gold price took place in September 2011, when a combination of expectations of a further round of QE, the downgrade of US debt and the worsening of the European crisis drove the gold price to an all-time high above US$1,910/oz.
Operation Twist
“Operation Twist” is a policy put in place by the Fed to push down long-term interest rates by buying longer-term government bonds, funded by simultaneous selling of shorter-term treasuries. The initial US$400bn operation carried out in 2011 was followed in June 2012 with an extension of the program by a further US$267bn. The recent extension of operation twist was greeted with some disappointment by gold investors who hoped a QE3 program might be announced.