Gold’s reputation as the ultimate safe haven asset has taken a beating lately, as the collapse in stock markets has forced investors to ‘sell everything’ in order to meet margin calls. Yet, that might be about to change. With central banks unleashing massive quantitative easing (QE) programs at a time when fear is controlling the markets and government debts are expanding, this could be the perfect mix to push gold back up to record highs. That being said, how fast the virus saga evolves will be crucial to determine precious metal prices.
In a crisis, all correlations become ‘one’ and it has happened before
Gold hasn’t performed like a safe haven at all lately, despite the crisis in financial markets. The recent losses are due to a ‘short everything’ approach. With leveraged funds taking heavy losses in stocks, many traders were forced to close profitable positions in gold to cover margin calls. In other words, the main reason for gold’s recent underperformance has been the speed of the sell-off in stocks. The collapse caught many investors off guard and without liquid assets to sell, forced them to raise cash by liquidating their portfolios, including gold.
In fact, this happened previously in 2008. The yellow metal fell with stocks in the first few months of the crisis until the Fed announced its first quantitative easing programme. This gave traders the green light to go long on gold again as the helicopter money meant they wouldn’t have to worry too much about funding constraints.
The sharp drop in the dollar following the 2008 QE announcement helped too as the dollar usually has an inverse relationship. Since gold contracts are denominated in dollars, a drop in the greenback makes gold cheaper for investors using foreign currencies, thereby boosting demand.
Monetary and fiscal policy, risk aversion and supply play a role
In the current situation, recent developments have been a perfect combination for gold prices. We might be entering a second phase of this saga where gold begins to act like a safe asset again. This is due to the fact that fear related to purchasing power has driven selling of the dollar which benefits gold.
Moreover gold benefits from lower interest rates. With central banks around the world cutting rates and yields on government bonds falling to zero or negative, gold suddenly looks much more attractive, even if it pays no interest. Adding to this, stimulus plans with QE programs after rates have been cut to zero, simply means that longer term interest rates will fall as well, boosting gold prices.
Furthermore, fiscal policies are still to be considered. Government deficits around the world are exploding due to the massive stimulus packages that have been set, and higher debts are an advantage for the yellow metal. A huge increase in debt naturally ignites concerns about whether governments will be able to meet their obligations, and whether that debt will be gradually monetised by weaker currencies.
Another factor arises when risk aversion becomes the obvious driver. Gold is thought to provide a hedge against all kinds of market volatility and turmoil, which will probably come in handy over the next months as the world enters a virus-induced recession.
Finally, there’s the supply side as the lockdowns in many countries have resulted in gold mines and refineries shutting down causing a supply shock. Hence, less gold will be mined and extracted in the near future, while demand is likely to remain high or grow even further, a combination which argues for an increase in price.
What about the risks?
While the overall environment currently seems to favor the yellow metal, it’s also important to know how it could go wrong. There are main downside risks for gold as it all depends on how the virus will evolve. For instance, if the virus situation is quickly brought under control and risk aversion declines, that would put a cap on demand for safe havens in general, not just gold.
Equally, if the situation gets out of control and worsens to the point of full-blown panic, that could see central banks and governments around the world begin to sell their gold reserves, either to defend their currencies, or to finance huge deficits. In other words, gold could lose in both cases - if virus fears calm down, or if the situation intensifies very quickly.
The final risk relates to the US dollar. A huge spike in the dollar could also affect gold demand. However, with the Fed doing its best to weaken the currency, a spike seems a little unlikely.
Conclusion: The big picture
The current situation seems set for a powerful rally in gold. Using history as a guide; a combination of worsening economic conditions, low interest rates and high debt could be the perfect combination for gold. A slow momentum towards the record highs of 2011 shouldn’t be ruled out, and a further decline in the dollar would be the icing on the cake.
That said, the speed at which the virus narrative improves or deteriorates will be crucial. The ideal situation for gold would be a slow and steady deterioration in the global outlook. Too slow, and risk aversion might fade out. Too fast, and the panic may become so overwhelming that players who otherwise want to hold gold, are forced to sell it.