Gold may be set on a perilous path as central banks withdraw the liquidity punch bowl that has driven stock markets to record highs.
As a world recovery gathers pace, the Federal Reserve is shrinking its balance sheet and raising interest rates, while the European Central Bank is about to begin tapering bond purchases. This scenario makes it very hard for a non-interest bearing asset like gold to do well, according to Troy Gayeski from SkyBridge Capital, which managed more than $11-billion at the end of August.
"Given the outlook for the Fed and down the road, the ECB, it seems highly unlikely that gold can thrive in that environment," said Mr. Gayeski, a senior portfolio manager. "We're a long way away from a very powerful gold bull market. That being said, gold could've already bottomed several years ago and trade sideways for many years until we enter the next great loosening cycle, which will come when the risk of recession goes up materially in the U.S."
The Fed started its latest tightening cycle in December 2015, with four rate hikes so far and another widely expected next month. While bullion has since climbed about 20 per cent to $1,273 an ounce, it's been mostly driven by a weaker dollar, the threat of nuclear war with North Korea, and to some extent, Brexit. Just recently, concern over the progress of U.S. tax reforms has stalled a record stock market rally and rekindled some risk aversion.
As the Fed starts to contract its balance sheet, other central banks are moving the same way. The ECB announced last month its bond buying will continue through September, although at 30 billion euros a month from January, half the current pace, while the Bank of England raised rates for the first time in more than a decade in November, and the People's Bank of China will probably intensify efforts to pare back a record buildup of debt in the financial system.
"A more normal global monetary system is a net-negative for gold," said John LaForge, the Sarasota, Fla.-based head of real assets strategy at Wells Fargo Investment Institute. "Gold, like many other commodities, typically performs best with loose monetary policies, including extra low real interest rates. The more 'normal', or less accommodative, global monetary systems become, the harder it will be for gold to rally."
While bullion may find support from lower real rates in mid-2018 as U.S. inflation peaks, consumer prices will probably ease in the second half, and nominal rates move higher, presenting "strong downside risk" to gold, Harry Tchilinguirian, commodity strategist at BNP Paribas SA, said in a note.
For others, it's less conclusive. There's no guarantee that Fed hikes will cap gold's upside, given persisting geopolitical uncertainty, Sandeep Biswas, chief executive officer of Newcrest Mining Ltd., Australia's top producer, told reporters Tuesday in Melbourne.
It's cheaper to hold a non-interest bearing asset such as gold when rates are low, which is why higher rates are thought to be negative for prices, says Matthew Turner, an analyst at Macquarie Group Ltd. "But in reality, gold rallied strongly in the last cycle, and was flat in the other two," he said. A historical analysis of gold in a tightening cycle shows "no safe conclusion," he said.
During the previous tightening cycle from June 2004 to June 2006, when borrowing costs rose to 5.25 per cent, gold surged more than 50 per cent. Before that, it rose about 6 per cent when rates climbed to 6.5 per cent between June 1999 and May 2000.
There may be an explanation. At the start of the last tightening cycle, gold was around $390. Prices had a long way to run because it was a "really orphaned asset class" for at least a decade, SkyBridge Capital's Gayeski said. There were also concerns at that time that the banking system was getting out of control and that inflationary pressures were more pronounced, he said. The situation is different now.
"It seems unlikely that inflation goes meaningfully above 2 per cent to 2.5 per cent anytime soon," Gayeski said. "As the Fed tightens further, real rates in the U.S. will gradually creep up to positive territory. Over time, one would suspect that as long as inflation stays contained, we'll at least have modestly positive real rates in the U.S. It's very hard to see gold doing tremendously well in a tightening environment."