Since my last gold-related column in February, gold price passed the $1,900 mark for the first time since 2011. Gold tends to thrive in times of uncertainty as investors stock up on the yellow metal as a haven. Despite the high uncertainty in the markets, the stock market has rallied from its March lows, due to the Federal Reserve’s stimuli and hopes of a rapid V-shape recovery. This rally hasn’t impeded gold’s bull run that could continue, as the U.S.’s economic recovery may stall and the Fed may need to provide more support to the financial markets.
The rise in Covid-19 cases in the U.S. has led many states to close down businesses and reverse some of the early recoveries in May/June in the job market and consumption. This second wave of Covid-19 cases is expected to manifest itself in leading economic reports, such as jobs and retail sales reports. If so, the weakness in the economic data could fuel more demand for gold.
Also, the uncertainty over the direction of the U.S. economy could prompt the Federal Reserve to act again and provide more stimulus. Since the Fed already slashed interest rates to the zero lower bound, it will need to resort to forward guidance and balance sheet related policies. The Fed already expanded its balance sheet to record levels at over $7 trillion by late May. However, the Fed may shift towards policies that will not require it to expand its balance sheet.
In the upcoming FOMC meeting, the Fed may hint of new steps it may introduce if the economy slumps. One policy it may consider is the yield curve control, or YCC. This policy of targeting Treasury yields at the backend of the curve could help lower short- and medium-term bond yields. So far, gold has benefited from low interest rates that are related to Fed’s policies on interest rates and quantitative easing. If the Fed were to hint of a YCC policy, this could provide backwind for the gold price and drive it to new highs.
The negative correlation between long-term bond yields and gold prices has remained stable and strong, as the chart below shows. As of July 2020, the linear correlation between the two was -0.51, indicating a significant and robust relationship between the two. As I have pointed out in the past, the negative correlation between long-term interest rates and the gold price has remained, for the most part, stable over the past few years.
Source of data: FRED, gold price (left) and 10-year Treasury bond yield
As for the Fed’s dual mandate of maximum employment and price stability, inflation remained well below 2% despite all of the Fed’s accommodating policies. And while unemployment fell to 11.1% (from 14.7% in April), it’s still high and may rise in the near term as more states shut down their economies. These economic conditions provide enough room for the Fed to introduce additional policies to combat the weakness in the U.S. economy.
Some reports show signs of recovery in physical demand for gold in China, as reported by the Economist. However, I think the main driving force of gold price isn’t physical demand for gold, but rather investors’ demand for gold. The data also support this assessment. A quick look at gold demand for Jewelry and Technology reveals that in 2019 it fell by 5% year over year, even as gold prices rose by 20%. Conversely, the demand for gold as an investment grew by over 9% year over year (see chart below).
Source of data: Gold.org, demand for gold on a sector basis in tonnes.
Moreover, since the start of 2020, only demand in the investment sector grew by 80% year over year, as presented in the following chart.
Source of data: Gold.org and Author’s calculations. Year-over-year change in demand for gold by sectors.
These findings suggest that even if the physical demand for gold in Asia were to keep recovering, it wouldn’t be enough to drive up the price of gold.
Another factor that could also provide backwind for gold is the weakening of the U.S. dollar. In the past, the linear correlation between the two was strong and negative. In 2018 and 2019, the correlation was around -0.6. However, in recent months, the correlation has weakened, as shown in the next chart.
Source of data: FRED and Author’s calculations. Linear correlation of gold and U.S. dollar, moving correlation over 24 months.
As the demand for U.S. assets grew in the first few months of the year, the U.S. dollar strengthened. However, this correlation could turn negative again, as the U.S. dollar has been losing ground in recent weeks due to loose monetary and fiscal policy along with the weakness of its economy. Moreover, if the Fed were to provide more stimulus or even hint of doing so, it could weaken the U.S. dollar and thus provide more support for gold prices.
Therefore, the main driver of gold will remain investors’ demand and how long-term interest rates and economic recovery progress. The optimism over a possible swift V-shape recovery appears too optimistic at this point. If the Federal Reserve is also worried about the recent developments in the U.S. economy, it may hint of possible new policies it could utilize in the near future as economic conditions worsen. If so, gold bulls are likely to see some additional gains.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.