Gold Soared, but Why?

The price of gold soared in Q1, but a bumpy road lies ahead.

Not so long ago, gold suffered the most challenging losses since 1999.  According to conventional wisdom, US rate hikes will contribute to its further decline. If that’s the case, why did gold prices soar during the last quarter?

At the turn of 2015, gold was driven by the broad commodity sell-off, especially the drastic plunge of oil prices that was fueled by the stronger dollar, along with concerns over China’s growth deceleration. Yet, the reality is that gold has low correlations with commodities and other asset classes.

In the past quarter, gold enjoyed a historic rally, soaring 17 percent — the best in nearly three decades. In the process, it outperformed other major asset classes, including stocks, bonds and commodities.

US rate hikes and Chinese demand

Until recently, the conventional wisdom was that the continued recovery of the US economy would support the dollar and the next rate hike, which, in turn, would pave way for gold’s further decline. It was conventional wisdom at its best — persuasive but flawed.

US recovery does not mean a return to the pre-2008 world, but the start of the post-2008 era of long stagnation. As a result, rate hikes will be lower and have longer intervals than anticipated. Structural constraints will keep global growth prospects far lower than conventional wisdom presumes.

As the Fed is debating the role of the rate hikes, central banks in Europe and Japan continue to maintain quantitative easing and record-low interest rates. In the short-term, these de facto negative interest rate policies increase potential for destabilization, by contributing to currency friction, swelling balance sheets and asset inflation.

In view of gold, negative interest rates matter. Historically, periods of low rates correlate with gold returns that are significantly higher than their long-term average.

What about the role of China?

In relative terms, China’s demand has eased after the 2013 highs. In March, the People’s Bank of China increased its gold reserves by the smallest amount since starting to release data on a monthly basis last year. Nevertheless, as China’s public demand for gold has slowed, its private-sector demand is climbing.

Today, China is the world’s largest gold consumer and producer, but only a few Chinese companies, such as Zijin Mining Group, have bought mines abroad, unlike their peers in industrial metals. However, things are changing. Despite their recent growth, gold prices are still trading close to levels last seen in 2010. Reportedly, Chinese gold miners are scouting for overseas acquisitions, encouraged by lower gold prices. These well-capitalized companies are positioned for global expansion.

As Chinese GDP per capita continues to double within the decade, consumer demand is likely to strengthen. Meanwhile, the PBoC will continue to increase its gold reserves, if only for diversification and to reduce dollar reliance. By the same token, Indian growth is likely to support similar trends.

Bumpy short- and medium-term futures

If anything, investors’ confidence in fiat currencies is diminishing, thanks to uncertainty about global growth, equities and dollar, as well as monetary injections that are seen as necessary but increasingly ineffective.

In relative terms, the relative role of the US dollar is slowly declining in the world economy. In the fall, the yuan will officially take its role among the reserve currencies of the International Monetary Fund. That, too, will contribute to the easing of the world’s dollar-dependency, though gradually and over time.

In the final analysis, US rate hikes are likely to penalize gold prices in the short term. However, the spread of stagnation in major advanced economies will sustain negative rates and QE rounds in Europe and Japan for some time — and the US will not be immune to spillover effects either.

While gold’s medium-term future looks bright, its short-term trajectory will remain bumpy.

Gold’s Bright but Bumpy Future is republished with permission from The Difference Group

See also: Could Gold be Forming a Bottom?