Whenever a market takes out an all-time high or an all-time low, pay attention.
These technical breaks are significant. Often investors become nervous when the price is at an all-time high or all-time low. However, price is often at record levels due to unusual circumstances and particular market conditions. This is the case for gold. During the month of July, gold took out the previous all-time high and shortly after hit the $2,000 level. The market conditions also happen to be perfect for more gold upside into the end of the year and as gold pulls back expect medium-term buyers to step in.
What are the main reasons behind gold's recent rally?
The main fundamental reasons for gold's rally are as follows. Firstly, very low global interest rates mean that it is less attractive for investors to stay in cash. Gold is just more attractive in a low-interest rate world especially if/when inflation rises. Secondly, some money managers project poor returns expected in equity markets as prices are seen as too elevated compared to earnings potential.
Many longer-term investors are concerned that Covid-19 is going to hinder economic recovery for the medium term and drag down equity markets. This adds to gold's appeal as an alternative place of value. Thirdly, one aspect that is worth looking at in a little more depth is the effect of Quantitative Easing on gold's recent rally and how that fuels gold's rise higher.
How does Quantitative Easing (QE) impact gold?
Quantitative easing (QE) is a tool by which central banks inject money directly into an economy. Money can be physical, like banknotes, or digital like the money in our bank accounts. That digital money is then used by central banks to purchase things like government debt in the form of bonds. As large scale purchases of government bonds are made using the money from QE, the interest rates or 'yields' on those bonds fall. This helps keep interest rates low and QE works by making it cheaper for households and companies to borrow money which in turn encourages spending.
This also boosts the appeal of gold. As QE reduces interest rates around the world it is less attractive to stay in cash. Other investments, like gold, become more attractive. The rise of QE around the world has been a boost for gold prices and with US 10 Y bonds at record low levels this dynamic is supportive of ongoing higher gold prices. Another aspect that has supported gold prices is the US's central bank action. The Federal Reserve is the world's most influential bank and it has been supporting gold over recent weeks.
The Federal Reserve's monetary policy supports gold
The minutes from June's Federal Reserve meeting show that the US is not anticipating any interest increases until 2022. You can see on the dot plot (a tool to show the Fed's forward anticipation of interest rates) that only two FOMC participants expect rate increases by 2022. This means that low-interest rates are expected to continue. A low-interest-rate environment is supportive of higher gold prices.
Furthermore, real yields are negative. When you take yields (US 10-year) and minus the current inflation level, the yields show that they are in fact negative. This means you simply lose money buying bonds when you take inflation into account. This drives gold's appeal for investors which is normally unattractive because it does not have a yield/dividend. If you look at the chart below showing real yields and gold prices you can see the connection.
ETF funds show record levels of gold demand for the first half of the year
There are now also record holdings in gold ETF's. According to the world gold council, gold ETF inflows reached a record 734 tonnes in H1. The first half of inflows sur-passed the 2009 annual record of 656 tonnes and lifted global holdings to all-time highs of 3621 tonnes. In fact, global holding of bullion-backed gold ETFs now out-strip Germany's entire official holdings.
Where will the top in gold be? Can gold reach $2,300 by year-end?
Of course, it is impossible to call a top with certainty, but the fundamental condition for gold means that more upside is favoured over the rest of the year as long as market conditions remain as they are now. Goldman Sachs says gold will hit $2,300 in the next year, driven by rock-bottom interest rates.
What is the bearish case for gold?
The bearish - or sellers' - case for gold will revolve around a swifter-than-expected Covid-19 global recovery. This situation would arise if there was really good treatment or cure for Covid-19. The first major indication that gold's bull run has come to an end would be rising interest rates from central banks around the world led by the Federal Reserve. This would be the cue that savvy investors use to stop buying gold on the dips lower and start selling on the rallies higher.
The views/opinions expressed in this article are those of the author and do not necessarily reflect the views and opinions of Al Bawaba Business or its affiliates.
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