Why gold is on a roller coaster ride
Jiang Huadong
The volatile trend of gold reflects the divergence of market expectations for the trend of gold.
Tightening monetary policy in major economies and persistently high inflation, the two conflicting factors are the key reasons for the volatility of gold prices and the different expectations of all parties.
Where the gold market will go in the future depends on the balance between the major mutual constraints.
In the early morning of February 16, a news of Russia's partial withdrawal of troops from the Russian-Ukrainian border caused spot gold and CME gold futures prices to fall rapidly, falling more than 1% during the session, reversing the previous upward momentum.
This volatile situation reflects the market's divergence in expectations for the trend of gold.
In fact, after the gold market fluctuated in the second half of 2021 and the first net redemption of gold ETFs since 2015, there have been various opinions on how the gold market will go in 2022.
Tightening monetary policy in major economies and persistently high inflation, the two conflicting factors are the key reasons for the volatility of gold prices and the different expectations of all parties.
Looking back on 2021, after the price of gold broke through to a high level in May, the game of these two factors dominated the market outlook.
It's just that the market at that time believed more in the Fed's "temporary inflation theory", and the property and value of gold as a hedge against inflation weakened, resulting in a gradual fall in the price of gold.
Gold prices continued to fall after the Federal Reserve completely changed its monetary policy expectations at the end of the year.
Markets remain divided on the outcome of the battle between these two forces in 2022.
Some investors believe that the Federal Reserve will be a key factor in determining and influencing the price of gold.
As an important indicator of the opportunity cost of holding gold, the real interest rate level of U.S. Treasury bonds has always been the focus of all parties concerned about the trend of gold.
In 2020, the price of gold exceeded US$2,000 per ounce, at a time when the major central banks made efforts to lower real interest rates under the new crown pneumonia epidemic.
Therefore, some institutions believe that under the recent more hawkish policy stance of the Federal Reserve, the price of gold will face huge pressure during the year.
However, the World Gold Council believes that “rising rates bring risks, but the details make or break”.
Nominal rates are expected to remain low from a historical perspective, although some central banks will start raising rates.
At the same time, the current persistently high inflation is expected to bring down real interest rates.
Therefore, while the cost of holding gold has risen, real interest rates that are still below historical levels will keep the opportunity cost of gold low.
At the same time, the environment of low real and nominal interest rates has made investors' portfolios more weighted towards riskier assets in pursuit of high returns, which has increased investor demand for high-quality and highly liquid assets such as gold.
From a market perspective, it seems that the latter is more convincing.
In fact, with the change in the Fed's statement, the real interest rate of the US 5-year Treasury bond will obviously enter an upward channel in December 2021; however, the price of gold has not made an excessive negative reaction to this.
There are two explanations for this situation: First, the bull market forces in the gold market place more emphasis on inflation than the market had previously expected, believing that persistently high inflation can further lower real interest rates and thus lower holding costs.
Second, some investors may overreact to the impact of the Fed’s rate hike. The bull market in the gold market is more inclined to believe that even if the Fed raises rates, the macro fundamentals of the United States and major developed economies around the world will not allow excessively high real interest rates. Lower real interest rates will also be supportive for gold prices.
Therefore, if the price of gold is analyzed purely from the trend of monetary policy and inflation, the trend of gold in 2022 may not be a single linear relationship or a single trend, but more depends on the intensity and frequency of interest rate hikes and whether the interest rate market trend will exceed previous expectations.
In fact, from a longer historical period, it is controversial whether short-term interest rate hikes or tightening monetary policy can change the long-term trend of gold; what really affects the price of gold is the US money supply M2.
Although the Fed may tighten monetary policy more than expected in 2022, it is worth noting that compared with the end of 2019, the US M2 has increased by 36.47% at the end of 2021.
At the same time, the size of the Fed's balance sheet has risen from $4.3 trillion at the end of the first quarter of 2020 to $8.79 trillion at the end of 2021.
These factors will provide support for gold prices in the medium to long term.
Similar to the logic of monetary policy affecting the price of gold, there is also the relationship between the trend of the US dollar and the price of gold.
Some investors believe that the current monetary policy divergence between the United States and other economies may further push the dollar higher, which in turn has a negative impact on the price of gold.
The World Gold Council believes that the relationship between the US dollar and gold is not a highly corresponding negative correlation.
The data shows that before and after the first rate hike of the four Fed tightening cycles in 1994, 1999, 2004 and 2015, the relationship between the US dollar and gold prices was inconsistent at different time points.
In the 6 months before the interest rate hike, the market mainly showed a negative impact on gold and a positive support for the US dollar index; in the 6 months after the interest rate hike, the US dollar index tended to decline by 3.95%, while gold showed a 11.34% decline. In the 12 months after the rate hike, the US dollar index rose by 2.21%, and gold also rose by 7.62%.
Another key factor affecting the investment properties of gold is investors' investment preferences, especially their attractiveness compared to other major asset classes.
In 2021, global gold ETF holdings will fall by 173 tons, and total assets under management will fall by 9% in value terms.
Market analysis believes that the steady rise in the valuation of US stocks, especially the valuation of technology stocks, combined with the impact of rising interest rates in the later period has weakened investors' preference for gold to a certain extent.
It is worth noting that since the beginning of 2022, the US stock market has been volatile.
Investor sentiment, which had previously supported some sectors, is shifting.
Under the variables of potential interest rate hikes and subsequent epidemics, the Nasdaq 100 index, where technology stocks gather, has gradually underperformed the S&P 500 index.
Therefore, some investors believe that in the current market environment, the value of gold as an investment position stabilizer will be further highlighted.
The final key variable affecting gold price action is risk aversion.
The investment property of gold as a safe and risky asset means that it can often hold various risk premiums.
As mentioned above, the evolution of the conflict between Russia and Ukraine has caused the global gold market to fluctuate. In 2022, when the epidemic has lasted for two years, "tail risk" has become an important factor affecting investors' preference for gold.
Whether the mutated strain of the new coronavirus will appear again in the future, how the geopolitical tensions brewing around the world will develop, and whether the high valuation of the stock market driven by the ultra-low interest rate environment will be pierced, these factors are provoking investors. sensitive nerves.
Therefore, some institutions believe that despite facing various risks and pressures in 2022, gold is still the best risk management tool in the hands of investors.
In general, in 2022, gold will face the combined effects of multiple "repelling" factors.
Favorable factors include persistently high inflation in the short term, market volatility caused by the epidemic and geopolitics, as well as a longer historical period of low interest rates, ultra-high money supply, and high central bank balance sheets.
Headwinds mainly include rising nominal interest rates and a potential continued strengthening of the dollar.
The future of the gold market depends on the balance between the above-mentioned major mutual constraints.