The gold standard: what is behind bullion’s best run in years?

Julian Turner 21 October 2019 (Last Updated October 7th, 2019 11:48)

Gold prices remain steady after rallying by 8% in August against a backdrop of tensions between the US and China and fears over an economic recession. Julian Turner talks to Ross Strachan of Capital Economics about US interest rate policy, declining bond yields and how gold miners view the market.

The gold standard: what is behind bullion’s best run in years?

Speaking on an episode of CNBC’s Closing Bell on 16 August, HSBC’s chief precious metals analyst Jim Steel neatly summed up the market conditions that are required in order for gold prices to rally.

“Gold needs a diet of intrigue or bad news to keep going up,” he commented, adding that a period of consolidation was now likely after gold prices jumped 8% in August and 18% for the year to date.

“I never thought that I would have seen gold yield more than a bond,” Steel added, referring to one of the main drivers behind the gold rally; namely the decline in bond yields, the result of renewed trade tensions between the US and China, and fears that the US economy may tip into recession.

“The key drivers of the gold price differ over time but in the short term at least it is often driven by investor flows,” explains Ross Strachan, senior commodities economist at Capital Economics.

“In the current rally investment demand has been at the fore and this has been driven by expectation of major monetary easing by various central banks (particularly the Fed) leading to plummeting bond yields.

“This has led to an explosion in negative yielding debt, to over $17 trillion, which has turned on its head a traditional drawback of investing in gold – namely that it has no yield.”

The yield curve: the link between bond profits and gold prices

Long-term bonds typically produce higher yields; for example, the US 30-year Treasury bond has in the past decade yielded around 3% on average per year. Thus, investors in bonds are compensated for the risk of holding the debt for a longer time. Recently, however, the ‘yield curve’ has inverted, with traders ditching riskier assets in favour of perceived ‘safe haven’ assets such as bonds and gold.

“Gold is seen as a safe haven (or even by some the ultimate safe haven) as it often exhibits the attribute of rising in times of heightened geopolitical or economic tensions,” explains Strachan. “Underscoring this is its inelastic supply that is geographically spread and its longstanding demand.”

The Financial Times reported that the 30-year US Treasury bond yield dropped to as low as 1.916% in mid-August, its lowest level on record and the first time it has fallen below 2%. Ditto, the UK 30-year gilt, which fell below 1% for the first time. Both signal that investors are expecting a downturn.

Will the US Federal Reserve react to falling bond yields by aggressively cutting interest rates to stave off recession? The market is not so sure. On 31 July, the Fed downplayed its decision to cut rates by 0.25% to 2.50%, a move chairman Jerome Powell referred to as merely a “mid-cycle adjustment”.

Following the US Federal Reserve’s dovish stance on interest rates in June, the gold price reacted by jumping to a six-year high as investors sought to secure an additional layer of portfolio protection.

The reaction was not as bullish following the Fed’s latest rate cut in late July, but prices still rallied past $1,450 an ounce in electronic trading, and at the time of writing remains above the key level of $1,500 an ounce as investors await news about further interest rate cuts before going long on gold.

“We expect the Fed to cut rates in September by 25 basis points (bps) and by a further 25bps later in the year,” says Strachan. “Typically, this would be expected to be bullish for gold prices; however, we think that market expectations both in the near-term and further ahead are for even steeper cuts and hence we think it is possible that when they reassess the likelihood for this stimulus that gold prices drop back a touch.”

Gold rush: how miners have reacted to price increases

According to the 2019 GFMS Gold Survey, reported global gold mine production in 2018 stood at 3,332t, an increase of 2% compared with the previous year and the largest year-on-year growth in the past four years, with the driving forces being operations in Argentina, the US, Russia and Mali.

However, just as the price of the precious metal has (temporarily, at least) levelled off, the World Gold Council (WGC) believes global production may do the same following the recent upward trend.

“The leading global producers of gold are China, Russia and Australia, although significant quantities are mined in a whole host of other countries as well,” says Strachan. “Production has been trending higher over the past decade and at present is even outstripping demand for physical bars which has softened sharply since the latest price increase.”

How have gold-mining companies reacted to the recent price rallies?

“Gold mining companies tend to not make production decisions on short-term price increases,” Strachan responds. “A small number of miners have hedged their positions to lock in current high price levels and we are seeing increased M&A activity in the sector.”

Future proof: can the price of gold rise still further?

In dollar terms, gold prices remain close to the six-year peaks achieved in August, and all-time highs have also been recorded in other currencies, the rouble, sterling and Australian dollar among them.

Strachan notes that, in addition to the aforementioned decline in bond yields, concerns about the elevated level of the US stock market and rising fears about the global economy, have sparked a substantial increase in holdings of gold-backed exchange-traded funds (ETFs), securities that track the gold price, trade on an exchange, just like a stock, and hold derivative contracts backed by gold.

Data from the WGC shows that in July, global investors poured about $2.6bn into gold-backed ETFs.

“What is more, we believe that central banks will buy more gold than they have for 52 years, with substantial buying from Poland, China and Russia,” adds Strachan.

So, how does Capital Economics see the gold market evolving in the short to mid-term?

“A key factor will undoubtedly be the level of bond yields in general, and those of US Treasuries in particular,” states Strachan. “It is likely that they will recover some of the dramatic decline that has occurred in recent weeks and that this will cause a decline in gold prices.

“However, this may also spark a recovery in offtake from China and India that will helped to cushion the price decline. In addition, central bank buying at stellar levels appears set to continue for years to come given the increased long-term desire in some key countries to de-dollarise their reserves.”