The last few months have seen gold prices getting hammered in the global markets. Gold is currently at its 14-month low in dollar terms and eight-month low in rupee terms. With global markets swaying to the tunes of trade wars and escalating international tensions, we are living in a time of extreme uncertainty. In such times, investors generally flock to the “safe haven,” however, that hasn’t been the case over the previous year. The gold markets have been witnessing a global sell-off on expectations of a further fall in prices. So, why is this happenening?
Factors causing the big fall
The dollar has been strengthening since the Fed has been hiking interest rates. Hence, investors have been putting in money in high yield US bonds rather than in gold. This has triggered a global sell-off in the metal. The shorting gold futures has hit a record high, with the difference between bets on the metal moving upward and those on the metal going downwards, scaling new heights.
Moreover, the dollar has grown stronger against the Indian Rupee and Chinese Yuan; hence, although the price of the metal has fallen substantially in dollar terms, the fall hasn’t been as intense for India and China, who are major contributors to the global gold demand.
Domestically, the demand for gold has weakened considerably. As per the World Gold Council, jewelry demand was down 8%, while investment demand fell 5% in the April-June quarter, thanks to the depreciating rupee which pushed gold prices upward. The devastating flood calamity in Kerala will bring a further fall in demand given that ~10% of gold demand in the country comes from the state, particularly during Onam.
Interest rates and gold prices: the critical connection
Interest rates and prices of the precious metal have been observed to have a negative correlation, that is, when interest rates rise, gold prices fall. However, the interest rates in consideration here are the “real interest rates”— rates adjusted for inflation.
The rationale behind this is the preference for holding interest-bearing instruments in a high interest rate environment compared to non-interest-bearing assets such as gold, whose returns entirely depends on appreciation.
The yellow metal, thus, becomes attractive over a low real interest rate period.
Gold prices and real interest rates have a non-linear relationship. The former increases substantially only in times of negative real interest rates, that is, when the inflation rate is higher than the nominal interest rate (rate that does not account for inflation), and in such times, bonds would actually result in a net loss.
Even historically, the biggest gold market booms have been witnessed in low real rate environments, for example, in the 1970s and 2000s, when both inflation and nominal interest rates were high. In 2015, gold prices fell on Fed hike expectations and a strengthening dollar vs. major currencies as well as high real interest rates.
Source: Bloomberg, IIFL Research
Thus, gold becomes a safe haven or a store of wealth, which is expected to at least be on par with inflation and preserve the purchasing power of the people.
This crucial connection explains gold price fluctuations with respect to interest rates.
So, where will it go?
Currently, gold is lingering around $1,200 per ounce, which is considered to be a threshold level for profitability in the gold-mining industry. If it falls below this threshold, production is likely to slow down. Thus, it all depends on the greenback’s strength and the US Fed’s decision on increasing interest rates. Last week, we saw President Trump criticize Fed’s policy of raising rates, providing some respite to the precious metal’s prices. Although the Fed rate hikes are not fixed in stone, it is expected to bring in two more increases in 2018 and three in the next year.
So, where is the yellow metal headed for now? Will it lose its sheen further? Is this a good time to buy gold?
While one may be opportunistic in times of high volatility, we will have to wait for the next Fed meet scheduled in late September to find out.