Gold analysis - managing the currency volatility

Gold is passing through a very difficult year with the precious metal currently losing 8% year to date.

Over the past months investors were very concerned regarding when and how the yellow metal will bounce back.

What has really pushed gold prices down?

Interest Rates

The Fed raised interest rates for a third time this year which has yet again dealt another blow to gold as it is very sensitive to US interest rates. When the FED increases rates, bond prices drop as new bonds are issued at a higher coupon to reflect the current interest rate environment.

When market valuations are stretched, similar to what we are experiencing now, investors tend to re-balance their portfolios towards safer assets.

Since bonds will be paying higher yields and gold does not pay income, investors tend to prefer bonds and thus making gold vulnerable to rising interest rates.

US Dollar strength

Gold was pushed down by the strength of the US dollar against both developed and emerging market currencies, particularly, a weakening of the Chinese yuan first and Turkish lira later. In fact, the dollar's strength has been one of the most important drivers of gold's negative performance this year as confrontational trade rhetoric and sanctions has so far played in favor of the US.

In addition, both the ECB and BOJ have delayed policy rate hikes, increasing differentials between interest rates in the US.

As we know gold is denominated in USD dollars and thus when the FED increase rates, money flows are attracted into the USD pushing dollar even higher thus gold price declines.

Why should we be positive about gold going forward?

Consumer Demand

Gold’s downtrend may likely support consumer demand as, historically, lower prices have driven jewelry buying, as recently happened in 2013, 2014, and 2015. For investors, gold’s current price range may offer an attractive entry level.

This is mostly proven in Emerging countries like India where consumers prepare for their traditional buying period.

Market Volatility

Historically, gold prices tend to rise as volatility increases. (see bar chart below)

Although volatility has been relatively low, investors now seem to start acting cautiously as flows from equity to bonds rose, as well as the consistent flattening of the bond yield curve in the US. The reason for this careful sentiment was due to several factors mainly:

- The current US expansion is the second largest in history (longest bull market in modern times pushing valuations to multi year highs)
- So far, effects of trade sanctions have mainly affected emerging markets – such as China or Turkey – but expanding or maintaining sanctions for a longer period will likely damage global growth
- Geopolitical risks on the rise by the increasingly nationalistic economic policies in many countries including the tough Brexit negotiations.
-  Central banks desire to maintain competitive currencies by means of low interest rates, may result in higher inflation. Gold is considered a good hedge against inflation and thus pushes the price higher.

The past has shown that any of these risks can be the catalyst that ignites strong investment demand for gold.

Bottom line

Gold is a highly liquid asset with no credit risk. It is normally bought both as a luxury good and as an investment and thus having exposure to Gold can play a fundamental role in a portfolio.

Personally I believe that the tide for gold is now turning and we should start seeing some positive momentum now until the end of the year.

As we highlighted before however, the major catalyst for the negative trend for Gold has been the strength of the US Dollar. This year for example, although we had periods of volatility, Gold still suffered.

In today’s market I think that it makes sense to have some gold exposure as we get closer to face more volatility, but as the US Dollar seems unstoppable, it might make sense to have yourself exposed to both assets.

By having positions in both GOLD and the USD index, you will be effectively gaining by exposing yourself into a safe haven during stressful times whilst at the same time protect yourself in times when the USD gets stronger.

As a way of example, by looking at the below chart we can understand that have we been invested in Gold this year we would have lost 8.35%. By being also long the USD index, we would have then gained 4.06% and thus our overall loss would be halved.

The benefits of such strategy is that whatever your belief about gold is, you can decrease substantially the impact that the USD might have on gold and thereby focus more on other market fundamentals.

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