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Dollar strength vies with inflation in battle for the future of gold

Published: 09:15 03 Jun 2016 EDT

gold

Will gold fall back through the US$1,200 level?

As always with the gold price, there’s a certain amount of opacity when it comes to making forecasts.

But in recent days, the basic price driver has been clear: as the dollar has strengthened, gold has weakened, and vice versa.

Indeed, the key to the sharp decline in the gold price in May, from nearly US$1,300 an ounce to closer to US$1,200, lies with the outlook for the US dollar.

Markets as a whole were taken by surprise when US Federal Reserve boss Janet Yellen indicated in May that a rate rise was likely this summer. Indeed, she said, there could be more than one rate rise, and they could start as early as June.

On the whole markets had been taking a more cautious line on rates, although newly released Purchasing Manufacturers Index data from the US seems to indicate that Yellen is right to think that the US economy can stand the strain.

All told though, the dollar is now likely to be stronger in the second half of 2016 than markets had been anticipating.

Gold, which is often used as a direct hedge against the US dollar, has therefore had to absorb this news.

And the smart money might well speculate that it will decline further when the mooted interest rate rises are actually announced - probably, according to market consensus, in July.

So the bull case for gold has been weakened, and the gold price has pulled back. So far, so predictable. Analysts at Capital Economics spoke last week of a possible dip to as low as US$1,000, whilst qualifying their comments with the notion that there are a lot of other “ifs” that need to be factored in.

It’s worth bearing in mind at this point that gold is still up around US$100 on the year, even allowing for the declines in May, and that this still makes it one of the better performing asset classes around.

And bear in mind too that the Fed’s first interest rate hike since the global financial crisis took place in December 2015, right at the point when gold hit multi-year lows.

From December until the end of April, it was all one-way traffic: up. So rate rises are not necessarily predictors of medium-term moves in the gold price, whatever the sentiment behind short-term trading decisions may be.

Because all though gold is in many ways a proxy currency, it can also be correlated to other commodities, in particular oil. Gold, says Capital Economics, is often in demand as an inflation hedge, and it’s quite possible that under certain circumstances this demand could outweigh the effects of rising interest rates.

One such scenario would be if the oil price rose and pushed up a US inflation figure that’s already on the rise still further. Indeed, it’s partly to counteract any over-exuberance in inflation that the Fed is looking to act on rates.

So it’s a complex balancing act that Yellen & Co. are attempting here, but one thing we know about the Fed is that on the whole what it cares about least is the price of gold. Inflation, interest rates and the oil price – these are of national strategic importance to US interests.

Gold, not so much.

So, if Fed policy does lead to a gold price spike that is probably a matter of relative indifference to Mrs Yellen. Likewise if it slumps.

This indifference is certainly a contributory factor in generated much of the agitated and febrile commentary that can surround the gold markets. How can the Fed possibly be indifferent to the gold price, when it’s the world’s oldest known currency?

The answer, of course, lies in that oft-quoted comment from former FT head honcho Lionel Barber, that gold is merely a “barbarous relic” of an age gone by.

Effective hedge? – yes on a small-to-medium sized investment basis. But instrument of policy? No.

The USA dismantled the gold standard back in the 1970s to pay for the Vietnam War and it has shown no inclination since to pay any real attention to the value of gold.

What that means is that gold is effectively the plaything of speculators, those interested in currency hedging and safe-haven investing against political uncertainty.

That’s why gold is more popular with retail investors in developing countries, in spite of its lack of yield.

But the value of your investment can go up as well as down, and in the case of gold, which isn’t really susceptible of fundamental analysis, rune-reading and esoteric speculation is ever popular.

Or to put it in the terms outlined by Capital Economics, there are a lot of “ifs.”

 

 

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