Volatile Gold in September 2022

Volatile Gold in September 2022 in spite of current pressure!

Gold dropped 2.6% in September on the back of the twin headwinds of a surging US dollar and higher bond yields. Gold remained volatile in spite of these challenges alongside pressure from futures net shorts and ETF outflows. The US dollar surge has been a major headwind for many assets in 2022 and probably its trajectory for the rest of the year will be a key determinant of gold’s fortunes. But the dollar is now facing its own challenges. Rising interest rates, typically another obstacle for gold, appear to be less important to investors now than they were in H1.

September was a challenging month for most assets, with global equities down 9.5%, global bonds down 5.1% and commodities down 8.4%. While a relative outperformer and thus a good diversifier, gold wasn’t the crisis hedge it has often been historically, certainly when measured in US dollars. However, for non-US investors, gold performance remains strong y-t-d. Adding to pressure on the US dollar gold price, gold futures fell to their shortest net position in four years. In addition, gold ETF outflows continued, with holdings falling 95 tonnes over the month. Price resistance under these pressures was, however, quite impressive: gold hit a monthly intra-day low of US$1,615/oz but recovered to end the month above US$1,670/oz.

Large positive residuals, captured by the ‘unexplained’ category, during 2022 are likely the result of an unquantified geopolitical risk premium in gold and/or a change in the sensitivity of gold to some of the underlying variables believing both factors are at play. In the case of a sensitivity change, probably investors are less concerned, but not unconcerned, about rising interest rates, as forward expectations of rates remain anchored at considerably lower levels.

The surge in the US dollar, up 15%in 2022 alone as measured by the US dollar index (DXY), has been a headache for many assets in H2 and is now becoming a rising burden for central banks. And the impact on gold has been two-fold. First, gold is most commonly quoted in US dollars, so, as it’s numeraire, a stronger dollar necessarily leads to a falling gold price. Second, this impact has been compounded in the recent rally by the dollar’s safe-haven demand, creating competition for gold. Outside of the US, gold has done well in both nominal and real terms. Two factors explain almost 90% of US dollar strength since late 2020 which are interest rates differentials and safe-haven flows.

Aggressive US Fed monetary policy tightening relative to other major central banks has made the US an attractive destination to obtain yield. Alongside this, the Fed’s overnight liquidity reverse-repo (RRP) facility has become a refuge for investors, doubling holdings from US$1.2trn to US$2.4trn in a year.

There might be 3 factors that could trigger a reversal, or at least a pause, in the US dollar, thus alleviating some of the pressure on gold either,
a) A historically high valuation and positioning in the US dollar relative to DXY components,
b) Central bank intervention in FX markets and/or bond markets or
c) Better aligned bond market expectations.

Only 3 years ago countries were vying for weaker currencies. Now they are anathema to economic health. Broad-based policy tightening to combat inflation has been undermined by dollar strength. So much so that active intervention in FX markets is now being implemented. The Bank of Japan (BoJ) intervened on 22 September, for the first time in 24 years. Whether their actions prove successful remains to be seen. But the fact that the yen, which makes up 15% of the DXY, remains the cheapest major currency, has a sizeable net short position against it, and the BoJ has the largest hoard of US dollar assets with which to defend its currency, suggests a significant risk of a reversal.Yen intervention was swiftly followed by similar action in China and India, not DXY components but an important signal nonetheless.

There have also been interventions in bond markets by the BoE (12% of DXY), indirectly supporting the sudden fall in the currency, and to a lesser extent the ECB (57% of DXY), with its support for Italian bonds. Interventions historically have been more successful when done jointly, (as in the Plaza Accord in 1985), so full-scale ECB participation might be required. Should this occur, the impact on the dollar could be material. A recent survey from Bloomberg showed that 45% of 795 respondents expected an orchestrated response to stop the dollar’s run.

A dollar turn is a positive outcome for gold too, but there are risks too. A dollar reversal would offer an almost immediate numeraire benefit. GRAM estimates a price elasticity of 0.88. This implies that, a 1% fall in the US dollar, holding all else constant, is associated with a 0.88% rise in gold. Hypothetically, a full unwind of DXY performance y-t-d return would imply a 13% rise in gold. Further, one possible outcome of a weaker dollar would be a risk asset rally, potentially threatening to exacerbate global inflation problems. This is positive for gold as it could draw more investors to gold as an inflation hedge, particularly in the absence of a dollar headwind.

A potential risk for gold is a disorderly offloading of US Treasuries, held as reserve assets, to defend currencies. This could push yields up further, raising gold’s opportunity cost. But an uncontrolled rise in yields would also present a whole new set of systemic problems which the US and other countries would most likely try to avoid, so that seems to be a remote risk.

Alongside the US dollar, rising US interest rates have also presented an obstacle to gold investment, with yields increasingly attractive to some investors. The rate-driven drag on gold may be lower going forward for 3 reasons such as: a) investors now appear to have priced in rising rates, b) investors’ sensitivity to rate hikes seems to have fallen, c) bond market forward expectations signal falling rates over the next 6-18 months.
The dollar likely will be a key driver of gold prices over the next few months and see risks to dollar strength primarily from valuation, positioning and further central bank intervention, which would be gold supportive. In addition, it appears that gold investors now view policy rate rises as less of a threat to gold than before.

They appear to have accepted Fed hawkishness and its terminal rate forecast. In addition, their sensitivity to Federal Market Open Committee (FOMC) announcements has fallen and the growing yield curve inversion and forward rate expectations signal a consensus expectation for lower rates ahead.