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Why are gold prices down despite a good time for gold investments?

A US recovery and the threat of the US Fed to raise interest rates has pushed some investors away from gold. But the Covid-19 pandemic is still around and it would be foolish to assume that things have become normal. But that is good news well for gold.

August 30, 2021 / 10:14 AM IST

Why has gold not rallied in this easy-money and inflationary environment? This question seems to be in every gold investor’s mind, and rightly so. There are many factors at play. And here, we attempt to decipher what is really influencing gold prices today.

Pandemic recovery: A false signal?

Investors tend to view gold as an asset to hold only during periods of heightened risk, as gold prices often rally during periods of uncertainty or market stress like they did in 2020. The US economy is recouping well from the pandemic, which is taking a toll on gold as investors increasingly prefer higher-yielding risk assets.

But this risk-taking ability is vulnerable to new variants and outbreaks of Covid-19, potential ineffectiveness of vaccines, inflation-related turbulence, bursting of bubbles in the stimulus-led stock markets, geopolitical and trade tensions. Also, investors seem to be discounting that gold is both pro-cyclical and counter-cyclical. While safe-haven demand tends to influence gold prices heavily in the short term, economic growth has a positive effect on gold consumer demand - the lion’s share of annual gold demand - over the long term. So if the current economic growth is indeed robust, strong consumer demand will support gold prices.

Also read: Here are the best ways to invest in gold


Relax; the US Fed is in no rush to hike rates

Apart from the risk-on sentiment, talk of monetary tightening by the Federal Reserve has further hurt gold prices off late. Yes, the Federal Reserve may tighten policy soon, and that is fundamentally negative for the metal. However, markets seem to be overestimating the pace, extent, and impact of policy normalization.

As of now, the accommodative policy stance still persists - the Federal Reserve’s benchmark rate is unchanged at near-zero, and the central bank will continue its monthly asset purchases at least till the end of this year. But investors seem focused on the future, even though that future is a good time away. The two proposed quarter-point interest rate hikes will come in a year and a half from now. Also, it is widely expected that tapering by the Fed is to begin only in the first quarter of 2022. Both low interest rates and elevated money supply are fundamentally positive for the yellow metal.

We have encouraging economic data coming in from the US, backed by the reopening of the economy, pent-up demand, and continuing monetary and fiscal stimulus. But what if the recovery isn’t sustainable or is prone to downside risks? Over the last year, we have seen signs of some softness creeping in as stimulus support wades paving way for another round of measures to lift growth.

Also, the rise in Delta variant cases across the United States continues to threaten the economic recovery. As such, premature tightening could throw economic recovery off track, given that businesses and governments have emerged on the other side of the pandemic with much larger balance sheets, and a large or quick increase in interest rates would increase their costs of servicing debt. As growth and stability remain the priority of central banks worldwide, this would give good reason to the Fed to withdraw slowly, keeping monetary conditions conducive for gold prices for longer.

The risk of inflation has not gone away

While an inflationary environment is good for gold, central bankers and markets seem to believe that the current high inflation is transitory, not giving gold its due as an inflation hedge.  If inflation is indeed transitory, the Fed would not have to worry about price pressures and interest rate hikes would, thus, be smaller and paced out to avoid derailing the economic recovery or increasing costs of servicing debt. A less hawkish Fed could be good for gold. And if higher inflation persists longer than the Fed believes, the delay in tightening could result in even higher inflation in the interim. Thus pushing real interest rates further in the red, benefiting gold.

Unlike earlier economic crises, when only gold was considered as an alternative to fiat currencies and a hedge against currency devaluation given its limited supply, the Covid crisis has brought cryptocurrencies, too, to the mainstream. Both asset classes have done well amidst the unprecedented global monetary and fiscal easing in response to the pandemic.

To beat inflation, investing in gold is better than cryptocurrencies

Diversion of some safe-haven flows into cryptocurrencies like Bitcoin has thus impacted gold prices. Cryptocurrency is a relatively new asset class with fewer participants and a debatable intrinsic value, which makes it susceptible to large price fluctuations and speculation. Gold on the other hand is less volatile on account of its well-established and liquid market, driven not only by investment demand but also consumer demand. Thus, investors with a much lower appetite for volatility and risks are better off investing in gold.

While fundamentals remain constructive, conflicting macroeconomic developments will keep gold prices range-bound in the near term. Investors should avoid going overboard and gradually build and maintain a 10-15% exposure to the strategic asset class.
Chirag Mehta
first published: Aug 30, 2021 10:14 am
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