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Though a little lower on the week, spot gold prices (XAUUSD) look set to round out the week with solid gains of about 3.7%, during which time the precious metal has rallied from lows of just above the $1700 level to the $1770 mark. At one point, XAUUSD nearly even managed to eclipse the $1800 handle, which it has not been able to do since February.
What has been driving gold higher?
Two major factors have been driving gold prices higher. The is the US dollar; USD and gold typically have a negative correlation (as when the dollar appreciates, dollar denominated gold becomes more expensive). Since the start of April, the Dollar Index (DXY) has dropped sharply from the mid-93.00s to as low as the 90.40s and currently looks on course to close out the month just below the 91.00 level and with losses of just under 2.5%.
A strongly risk-on bias to global markets (the S&P 500 is up more than 5% on the month, for example) has hurt demand for the US dollar, which is classically seen as a safe-haven currency. Moreover, the FOMC has sent a steadfast dovish message that monetary policy tightening remains a long way off, despite recent improvements in the state of the US economy – this hurt the dollar midway through the weak. What is bad for the buck is typically also good for gold.
The second major driver of upside in gold markets has been movements in US government bond markets, namely, a drop in real yields and a sharp rise of break-even inflation expectations. Non-yielding precious metals, which are seen as a safe haven asset, are sensitive to changes in the yield on US government bonds, which are also seen as a safe haven asset; typically when bond yields increase, this makes investing in bonds more attractive relative to investing in gold and thus attracts outflows from gold (or other precious metals), pushing the price lower.
However, what really matters is real yields (i.e. inflation adjusted yields) – if yields rise purely because inflation expectations rise, then this does change the attractiveness of bond relative to gold. Indeed, rising inflation expectations (driven by an increase in nominal bond yields relative to real bond yields) can actually be a positive for precious metals given their properties as a hedge against inflation.
For precious metals markets this month, it has been a double whammy positive signal from bond markets; US real yields are lower (10-year TIPS yields have dropped from just under -0.6% to current levels of just above -0.8%) and break-even inflation expectations (the difference between the yield on the nominal 10-year bond and 10-year TIPS bond, which is the real 10-year bond) have risen sharply, jumping from around 2.32% to above 2.40%, its highest level since 2013. Lower real yields increase the relative attractiveness of gold versus US government bond markets and higher inflation expectations increase demand for gold as an inflation hedge.
What next for gold’s main drivers (USD, yields and inflation expectations)?
The first thing to note here is that the US dollar and US government bond yields, particularly real yields, have a close correlation. In other words, if one goes up, the other is likely to go up with it. Though not always the case, over the medium-term, bond market price action typically leads the way – price action in bond yields closely reflects changes overtime in the interest rate environment and monetary/financial conditions in a country, something which FX markets then tend to follow.
Bond market price action over the last few weeks has been slightly odd – US data released this month (March jobs and retail sales data and April consumer and business surveys) has been super bullish and analysts as a result continue to become more and more bullish on the outlook for the country’s economic recovery. As the US vaccine rollout continues pace and the spread and deadliness of the Covid-19 virus recedes, states are rushing to reopen their economies. US consumers have accumulated huge savings over the past year amid restrictions on everyday recreational activities and a surge in spending is expected as lost time is made up for. Huge stimulus spending from the government, which has most notably included generous unemployment benefits and direct transfers worth $2000 to each American in 2021 alone is set only to add to the surge in demand and pace of recovery.
In such an environment, yields, at least on long-term debt would typically move higher in anticipation that a stronger economy will lead to higher interest rates and tighten monetary conditions. Not the case this month. As noted above, real yields have fallen. The fall in real yields has exerted downwards pressure on the US dollar, though analysts have also cited a better global outlook (notably the pandemic appears to have peaked in mainland Europe and vaccinations there are catching up with the US, which is helping EUR at the expense of the buck).
So the question is, if bullishness about the US economy continues to grow (perhaps we see further consecutive months of blowout jobs numbers, for example), will this translate into higher real yields, and would this push the dollar higher with it? The Fed, though maintaining their dovish guidance that monetary tightening is still a long way off earlier in the week, has not expressed any concern about a move higher in yields yet. If the answer to the above question turns out to be yes, this will note bode well for gold.
However, whilst the Fed maintains its ultra-accommodative monetary policy stance, the risk of further gold appreciation remains very much in place. In an environment where the economy is recovering rapidly and the central bank is refusing to budge from its dovish stance, this can contribute to a sharp rise in inflation expectations (as we have seen over the last few months). As discussed above, this is in itself a positive for gold, which is seen as a hedge against inflation. Moreover, when inflation expectations rise, this can put downwards pressure on real yields. Remember; nominal yields – inflation expectations = real yields. As discussed above, this would also be good for gold.
The Fed continues to argue that the current pickup in inflation, which is expected to peak over the summer (US Core PCE could get above 3% according to some forecasts), is “transitory” – i.e. a result of temporary factors such as 1) base effects (i.e. weakness in inflation when the pandemic first struck this time last year) and 2), as Powell said in the FOMC press conference this week, “bottlenecks”, which are short-term supply chain disruptions. The former factor might well prove to be transitory, but the latter factor (epitomised by the current global chip shortage) could persist for much longer. Meanwhile, the aforementioned surge in demand in the US economy is likely also to put significant upwards pressure on prices.
To sum up, there seems to be a clear risk that the Fed might get it wrong with inflation (i.e. that they underestimate the strength with which inflation returns). The Fed’s new Average Inflation Targeting policy means the committee has a newfound tolerance to allow inflation to overshoot the 2% target for a time. This means that when inflation does heat up, the Fed will continue to sit on their hands and hold rates at zero. This has the potential of being a very positive environment for gold, with the downwards pressure on real yields likely to outweigh any negativity towards gold as a result of bullishness about the US economy. However, the Fed continues to reiterate that it does have the tools to deal with excessive inflation and is not afraid to use them, so the risk of an inflationary spiral seems very low.
