World Gold Council: US dollar’s effect on gold overdone

The following is an edited investment commentary released by the World Gold Council in January. For more information, please visit www.gold.org.

At first glance, 2015 wasn’t good for gold. By year-end, gold’s dollar price was down more than 11%. Investor sentiment was bearish: average net-longs reached their lowest level since 2003, and gold-backed exchange-traded funds (ETFs) saw outflows of 100 tonnes for the year.

Better economic performance in the U.S. allowed the Federal Reserve (Fed) to raise its funds rate on Dec. 16, 2015 for the first time in 9.5 years. In the months before, higher bond yields strengthened the dollar, putting pressure on gold.

We believe that 2015 was an exception and not the rule. While the U.S. dollar certainly drives gold, there are two more important points to consider: it is not the only driver, and it is not always the most relevant metric for most investors.

The gold market is truly global, with more than 90% of physical demand coming from outside the U.S., mostly from emerging economies. For all these non-dollar buyers, it is the local price — and not the U.S. dollar price — that matters most. In fact, the non-U.S. dollar price of gold held up in 2015, even moving up in some currencies. Examples include gold’s price in Turkish lira, Russian ruble and the Indonesian rupiah. Additionally, the demand-weighted gold price (the local gold price multiplied by the percentage of annual demand a given country represents) has been, on average, 1% higher annually since the beginning of the century than the dollar gold price.

In the current landscape, we  see encouraging signs for the gold market. As of third-quarter 2015, both Indian and Chinese demand were up relative to the same period last year. Bar and coin demand was also up (including the U.S.). And while gold-backed ETF outflows continue, their pace has slowed. Central banks are also strong net buyers. Recycling continues to fall and mine production is likely to level off.

Gold’s most recent bull run between 2001 and 2012 was driven by various factors:

• Strong emerging market growth supporting consumer demand;

• The global financial crisis and its aftermath creating flight-to-quality flows;

• Financial innovation making gold easier to buy;

• Central banks’ shifting from net gold sellers to net buyers to diversify foreign reserves.

As the U.S. economy recovered and fears of deceleration in emerging markets took hold, gold prices fell. By the end of 2014, due to a perceived lack of a clear catalyst for gold prices, attention centred on the U.S. dollar and the eventual rate hike by the Fed.

But will this U.S.-centric view of gold continue? We believe it will not.

Historical perspective

Past performance is certainly not a guarantee of future performance, but investors can gain insight by understanding past cycles.

Since the 1970s gold has experienced five bull markets and five subsequent bear markets. While there has been less uniformity in the length and magnitude of appreciation in the gold price during bull runs, pullbacks have been more consistent. Previous bear markets (excluding the current one) have had a median length of 52 months, during which the gold price declined between 35% and 55%. Each of these declines was a fraction of the gains seen in the earlier bull run. As it stands, the current pullback is not far off the median bear cycle.

Historical performance without an understanding of the macroeconomic drivers, however, is not enough. For example, the most recent bull run was much longer than previous ones due to the factors explained above.

What about the current bear cycle? There are important conditions that are likely to make 2016 different from 2015.

Three reasons for optimism

The Fed increased the federal funds rate by 0.25 basis points during its last 2015 meeting. Widely anticipated by the market, this moved the target range between 0.25 and 0.5 basis points. However, what is not so certain is how quickly and how high they will raise rates to ‘normalize’ them (i.e., reach their terminal rate). The Fed expects to increase rates 1% by the end of 2016. Market consensus is more dovish and expects a Fed Funds rate below 1% by the end of 2016. Either way, rates may remain low for some time.

In our view, interest rates are not a dominant driver of the gold price once the effect of the dollar is taken into account. And the dollar has already strengthened more in the past two years than it has since the ‘dot-com bubble’ burst. In fact, the dollar is at the highest level it’s been at the beginning of a Fed tightening cycle since the 1980s.

This is important for two reasons:

• The dollar tends to revert back to its long run average, and after two years, many foreign currencies show signs of recovery;

• A strong U.S. dollar is a de facto tightening mechanism, which prevents the Fed from moving interest rates too far too soon, and risk crippling economic growth.

The Asian gold market continues to expand. In China, the People’s Bank of China’s periodical announcements on additions to their gold reserves from June onwards and the Shanghai Gold Exchange’s intention to introduce a yuan-denominated trading mechanism highlight the growing importance of this market. Similarly, the Indian gold trade has expressed its intent to establish a gold exchange in the not-so-distant future.

In addition, market risks abound. The interconnectedness of global financial markets has created a higher frequency and larger magnitude of systemic risks. Stock valuations in the U.S. remain elevated as investors increase their risk exposure in search for returns amid a low yield environment. In such an environment, bonds offer less protection to soften the blow of a stock market correction. And while macroeconomic conditions in advanced economies have improved, market and liquidity risks are close to record highs. In such an environment, gold’s role as a portfolio diversifier and tail risk hedge is particularly relevant.