Gold price is still down from its pre-US/Iran-war levels (Exhibit 1) while many other asset classes have retraced their losses. Why the underperformance and what lies ahead for gold?
Short-term reasons
Dollar’s strength
The dollar’s near-tern strength has reaffirmed its safe-haven status at the expense of gold’s status. The flight to dollar safety has temporary eased investors’ concern about the US’s high debt and twin (current account + fiscal) deficits problems. That has reduced demand for gold as a hedge against dollar debasement, or the loss of the dollar’s purchasing power due to these and other problems.
Official interventions
Notably, Turkey sold an estimated 60 tons of gold in March after the US/Israel-Iran war broke out on 28 February. The Indian government also delayed approvals for gold imports amounting to more than 5 tons. They employed these defensive measures to reduce selling pressure on their currencies.
ETFs selling
Gold-backed ETFs were estimated to have sold 90 tons of gold in March, or 60% of the 150 tons they had bought in January and February this year, as market expectations on US monetary policy swung from rate cuts to no cuts or even rate hikes.
These gold sales were short-term moves. Central banks, notably China’s (Exhibit 2), are still long-term gold buyers. Those defensive FX measures will reverse when currency depreciation pressure subsides.
ETF trading is contingent upon fickle interest rate expectations. Data so far in April shows that gold-backed ETFs have bought back half of what they sold in March as interest rate expectations have changed again.
Finally, the dollar’s strength will reverse when fears about the Middle East conflict fade or give way to the market’s long-held concern about dollar debasement. Demand for gold as a hedge against dollar risk should then return.
Fundamental reasons
Cost of carry
After rising sharply on inflation concerns stemming from the Iran war-induced energy shock, bond yields have only partially returned to the pre-war levels (Exhibit 3). This has made non-yielding gold less attractive in investment portfolios.
Different shocks
Demand shocks are usually positive for gold performance because monetary policy must ease to combat growth weakness. This policy reduces the opportunity cost of holding non-yielding gold, thus increasing gold demand and its attractiveness as a hedge against economic crisis. However, the Iran war has created a global energy supply shock. That has pushed up inflation and raised the market’s concern about central banks raising interest rates, pushing up the cost of carry for gold. The war has hurt gold as inflation and rate hikes worries become dominant.
The gold hedge and policy sensitivity
This means that gold’s expectation on monetary policy response has taken over as the key price driver since the start of the Iran war, overwhelming its safe-haven status and the benefits of owning gold to hedge against the crisis and inflation risks. In other words, gold has failed to function as a hedge against inflation and supply-chain risks in this crisis so far because the war has prompted rate-hike expectations, boosted yields, raised the opportunity cost of holding gold, and strengthened the dollar. The latter has eroded gold’s attractiveness as a safe-haven instrument.
Outlook
Barring a prolonged conflict, the inflation and energy shocks will be transitory with negative impact on growth beyond the short-term due to a destruction of confidence and purchasing power. At some point, the market’s focus will turn to growth risks and rate cuts again. Gold price will then rebound.
Central bank purchase will remain a long-term support for gold, prompted by geopolitical tensions and an increase in the incentive for de-dollarisation amid concerns about dollar debasement.
