Interest rates will likely remain a key driver for gold in the short and medium term. Yet, the negative impact that higher rates could bring will likely be offset by the longer-lasting effects and unintended consequences of expansionary monetary and fiscal policies created to support the global economy. These may include inflation, currency debasement, and higher exposure to risk-on assets in portfolios. Combined with attractive entry levels, these factors could prompt strategic investors to add gold to their allocation strategies and support central bank demand during the second half of the year. However, while consumers may also benefit from the economic recovery and recent price pullback, new COVID variants may limit uptake in gold jewellery in key markets.
High rates upstage inflation as gold underperforms
The first half of 2021 provided a good example of how gold’s diverse sources of demand and supply interact. The gold price dropped by 6.6% in H1,[1] as gains during most of Q2 were thwarted by a significant pullback in late June. Gold’s price also underperformed in most key currencies except for the Japanese yen and the Turkish lira, which weakened against the US dollar (Table 1).
Overall, gold’s performance was driven primarily by higher interest rates – especially during Q1 and then again in late June on the back of a more hawkish-than-expected statement by the US Federal Reserve.[2] Gold was also influenced by upbeat investor sentiment as the global economy started to recover from the impact of COVID-19. However, there were supporting factors for gold. Concerns of higher inflation offset part of the drag that interest rates brought. And the strong response from governments to aid economic recovery in the form of monetary and fiscal policies has made some investors worried about currency risks and capital preservation. In addition, gold benefited from a recovery in consumer demand in Q1, although second waves of the virus and new lockdowns presented challenges in Q2. Our short-term model shows that these factors, combined with the effects of price momentum and investor positioning, help to explain the vast majority of gold’s performance year-to-date (Chart 1).
Chart 1: Gold’s performance in H1 was driven by interest rates, inflation expectations and momentum
Contributions of gold price drivers to periodic gold returns*
Table 1: Gold underperformed in most currencies during H1 2021
Gold return in key currencies*
Risks for gold remain but there are also opportunities
Using QaurumSM,[3] our web-based valuation tool, we analysed hypothetical scenarios[4] based on research by Oxford Economics,[5] covering various potential macroeconomic developments. Namely,
• an accelerated economic recovery
• a consumer-led economic boom
• an environment where rapid rate rises offset inflation in later years
• a more cautious economic recovery
• an environment where new COVID variants severely impact the global economic recovery.
The results suggest that there is still upside potential for gold’s implied hypothetical performance during the second half of this year based on the conditions under consideration (Chart 2).[6] However, this is unlikely to come without challenges.
Interest rates as key drivers
The analysis indicates that gold’s performance could be heavily influenced by the movement of interest rates and the success of vaccination campaigns.
For example, a further rise in interest rates could continue to create headwinds for gold. This is consistent with gold’s historical behaviour in periods when monetary policy becomes tighter, often resulting in price pullbacks.
However, we believe that central banks will be cautious in terms of the speed at which they start to remove asset purchase programmes or increase interest rates. A hasty move could result in large market swings and potentially destabilise the economic recovery.
Chart 2: Oxford Economics scenarios and our valuation methodology indicate that there could be upside potential for gold
Full-year 2021 implied hypothetical returns*
In addition, investors have experienced a prolonged ultra-low interest-rate environment, and this is creating structural changes in asset allocation. Investors are adding more risk to their portfolios in search for returns which, in turn, has required them to revisit their risk management strategies.
Our analysis suggests that this could increase the need to hold assets such as gold for downside protection and diversification.
This applies not only to private individual and institutional investors; central banks have steadily increased their allocation to gold so far in 2021 and our research suggests they will continue to do so. And we believe that, collectively, they may deliver net purchases at the same rate or potentially higher than in 2020.
Inflation could come in different flavours
Inflation has become a key concern for many investors. But while inflation has been on the rise, there are mixed views as to whether the increase in consumer prices will be temporary or more sustained. If price inflation becomes persistent, history shows that gold could perform well. For example, gold had an annual average return of 15% in years when the US Consumer Price Index (CPI) was higher than 3%.[7] Our research also indicates that gold may respond to factors other than higher CPI inflation. Gold is highly correlated to broader inflation metrics such as money supply which is on the rise, and this could later result in inflation bubbles, currency debasement, and potential market volatility around the world. Global investors may thus look to gold as a means to protect against the erosion of capital.
Entry opportunities on price pullbacks
Following the significant price pullback in late June, the gold options market showed interesting dynamics. The so-called ‘put skew’[8] suggested that some of the selloff was likely softened by buyers. The price selloff also pushed gold’s relative strength index down significantly. And while some investors may remain concerned about downside risks, these metrics signal that others may see it as an entry opportunity – whether tactical or as a means to build strategic positions.
Consumer demand shows mixed signals
Overall, the global economic recovery and the recent price pullback should continue to support gold consumer demand. In China, for example, government stimulus, sales promotions, and seasonal patterns suggest stronger gold consumption during H2. In contrast, however, surges in COVID-19 cases due to new variants are significantly impacting key markets such as India.
Conclusion
The performance of gold responds to the interaction of the various sectors of demand and supply, which are, in turn, influenced by the interplay of four key drivers (Focus 1). In this context, we anticipate that the need for effective risk hedges will continue to support investment demand, but gold’s performance will also be influenced by the direction of interest rates and the robustness of the economic recovery.
[1] As of 30 June 2021, based on the LBMA Gold Price PM in USD.[1] As of 30 June 2021, based on the LBMA Gold Price PM in USD.
[2] Federal Reserve FOMC statement, 16 June 2021.
[3] Qaurum is a web-based quantitative tool powered by the Gold Valuation Framework (GVF). An academically validated methodology, GVF is based on the principle that the price of gold and its performance can be explained by the interaction of demand and supply. In turn, demand and supply are influenced by macroeconomic scenarios that can be customised to calculate gold’s implied performance based on these hypothetical conditions over various time periods. See Important information and disclosures at the end of this report.
[4] As of Q2 2021. A detailed description of these scenarios can be found in Goldhub.com. See Important information and disclosures at the end of this report.
[5] Oxford Economics is a leader in global forecasting and quantitative analysis and a specialist in modelling. Their scenarios are based on their Global Economic Model updated as of 26 May 2021.
[6] All results herein are hypothetical. See Important information and disclosures at the end of this report.
[7] As of 31 December 2020. Based on y-o-y changes since January 1971 for gold based on the LBMA Gold Price PM USD, and for inflation on US CPI.
[8] Defined as the difference in price between at-the-money options and options that are struck out-of-the-money.
Important information and disclosures
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Information regarding QaurumSM and the Gold Valuation Framework
Note that the resulting performance of various investment outcomes that can generated through use of Qaurum, the Gold Valuation Framework and other information are hypothetical in nature, may not reflect actual investment results and are not guarantees of future results. WGC provides no warranty or guarantee regarding the functionality of the tool, including without limitation any projections, estimates or calculations.