Can gold really act as a hedge?
With the Federal Reserve due to meet next week, Samy Chaar, investment strategist at Lombard Odier, discusses the outlook for gold amid ongoing market fears and potential Fed repricing.
The rally in gold prices (+27% year to date) was impressive during the first quarter, as well as after the Brexit shock, largely as a result of falling US real interest rates. When we revised down our expectations for the peak of the US Federal Reserve (Fed) tightening cycle in May, we upgraded our positioning on gold to neutral. Despite current investor appetite for the commodity, we would not recommend adding more exposure, as the downside risks seem larger than the upside potential. We expect prices to range between USD1200-1400/oz over the coming months with market fears and Federal Reserve repricing. We see more hedging potential on US bonds, especially on the long end of the curve.
From a fundamental standpoint, physical demand is likely to remain weak as gold prices are still close to all-time highs when denominated in emerging market currencies, especially Indian rupees.
However, gold moves have nothing to do with fundamentals but are dependent on financial demand. Indeed, with negative interest rate policies implemented by several major central banks diminishing the hedging capacity of traditional safe-havens, such as government bonds, the appeal of gold is reinforced during periods of market turmoil. As a result, in the first half of 2016, gold ETFs enjoyed their strongest inflows since 2013.
Taking a position on gold today means taking a very bearish view on the Fed – US dollar and real rates are the most stable drivers of gold over the long run. With mounting wage pressures, the likelihood of a re-pricing of the US tightening cycle by the end of the year – even a gradual one – should not be underestimated. Given current complacent market positioning, this dynamic could lead to a marked sell-off in gold, similar to those experienced in November 2015 (-10%) and May 2016 (-7%).
In addition, even if we think that the low-rates environment is here to stay, possible fiscal tailwinds in the US are likely to limit downward pressures on rates. In all, we see limited upside for gold prices from the point of view of our baseline scenario of a still-stable US growth / limited downside for US real rates / absence of systemic risks. Notably, a scenario of lower growth and deeply negative real rates in the US – as witnessed in 2012-2013 – is far from our baseline scenario.
Gold moves are almost entirely fuelled by financial demand, itself fuelled by market fears. Therefore, we expect gold to remain particularly volatile, ranging from USD1200-1400/oz over the coming months. This is likely to penalise its return-to-risk profile and makes it less attractive from a multi-asset perspective.