is having a moment; one we believe is likely to continue. The precious metal has risen over 8% so far in 2023, thanks to a combination of positive factors. Here are three reasons gold has been moving higher and why investors may consider making a tactical allocation.
The end is near: There’s no guarantee, of course, but it’s likely the May rate hike will be the last of the Federal Reserve’s tightening campaign, which began in 2022. Expectations of a Fed pause have prompted weakness in the dollar, benefiting gold which is priced in dollars.
Concurrent with the dollar’s drop, inflation-adjusted 10-year yields have fallen by approximately 50 basis points from their late 2022 high. Falling real rates and a weaker dollar are a strong backdrop for gold. An analysis comparing 5-year real rates and spot gold prices showed a strong negative correlation over the past 20 years, meaning gold and real rates tend to move in opposite directions.
Chart description: Line graph showing 5-year real rate levels and gold prices from May 2003 to May 2023. The graph shows that in periods of consistently low real rates, gold prices tend to rise.
GOLD PRICES SPIKE AS REAL RATES FALL
To be sure, we don’t share the consensus view that the Fed will be cutting rates in 2023, which presumably would accentuate the downward trends in the dollar and real rates. But the Fed staying on hold is our base case and that should support gold at current prices.
A body in motion: Falling real rates and a weaker dollar provide the fundamental backdrop to gold’s recent really. There are also technical and psychological factors supporting the precious metal.
Gold has tended to perform well during periods of heightened market volatility. For example, when investor fear jumped in March amid regional bank failures, investors turned to gold as a relative ‘safe-haven’. Year-to-date, exchange-traded gold funds have seen $2.7 billion of inflows, with most occurring in April after March’s volatility. 4
Investors often turn to gold as a way to diversify portfolios amid financial market volatility. Gold historically has a low correlation with broad U.S. stock and bond exposures. In the last 20-years, monthly price correlation between gold and the S&P 500 was 0.09, meaning there was virtually no correlation between stocks and gold; correlation between gold and the Bloomberg US Bond Aggregate Index was 0.38, showing little to no historical correlation.5
While it is unclear if and when another shock may hit, investors may choose allocations to gold as a potential hedge against future unrest.
GOLD AS A HEDGE
Many investors view gold as an inflation hedge when, in truth, the relationship between gold and inflation is nuanced. As noted above, gold has tended to trade in closer relationship to real rates and the dollar vs. inflation per se. Notably, spot gold prices were rangebound in 2021, when U.S. inflation rates surged.6
In fact, gold may be likely to perform better going forward if – as we expect – the U.S. economy continues to slow, perhaps falling into outright recession, and inflation declines. That’s because the Federal Reserve is unlikely to raise rates again if the economy – and inflation – are in retreat.
Historically, as rates rise, investors turn to fixed-income exposures where they can clip a higher yield. Since gold is a non-yielding asset, a rising rate environment tends to make gold unattractive. Now, as the Fed prepares for a likely pause, we see an environment where gold may perform well. Secondly, the weakening U.S. Dollar makes gold more attractive to foreign buyers since gold is denominated in dollars. The gold market is largely supply and demand driven, so, we can expect support for gold prices from elevated international demand.
Rather than an inflation hedge, gold can be viewed as a potential hedge against geopolitical risks.
With a contentious Presidential election in the offing, it’s unlikely U.S. political acrimony will subside anytime soon. That said, the big area of bipartisan agreement in U.S. politics centers on containing China’s growing economic and political clout. Gold seems likely to benefit, as it did when Russia invaded Ukraine in early 2022, if geopolitical tensions rise.
In the short to medium-term, we see structural support for gold as we expect the Fed to pause rates at the next FOMC meeting.
Notably, gold fell from its May 3 high around $2050 per ounce amid expectations the U.S. would avoid missing the deadline to raise the debt ceiling.7 That said, the decline occurred after gold rallied nearly 30% from its 52-week low.8 If gold proves able to sustain a rally above its 10-year high of $2067, that may suggest another leg in the rally is likely.
Investors may consider a tactical allocation to gold in an environment of a slowing economy and stabilizing real rates. Exchange traded products provide a low-cost, efficient way to gain exposure to the price of physical gold.
Contribute by Gargi Pal Chaudhuri from Interactive Brokers
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