Markets

Gold on rebound? Look what is giving the metal the strength

By Aasif Hirani

Gold has seen some rough weeks. For the past five months, it has been trading in sideways consolidation and then, the expected sell-off happened.

Short covering in gold proved very short-lived and now, its near its support zone of $1,345. There are some points that work in favour of gold.

First is inflation, which has started to gather momentum. Inflation is crucial to gold prices, after of course the dollar. Inflation has started to gather momentum after crude oil prices started spiking upwards. Until now, inflation was kept artificially low by advanced economies by monetary manipulation and staggering deficits.

US CPI (consumer price index) is at 2.8 per cent. As seen from this chart, the main contributor is oil prices, but the prices of crude started accelerating from start of this year. US inflation has started rising from last year.

Let us exclude volatile items such as food and crude prices. If we take out crude prices, which expanded maximum after food, US CPI should be steady. However, despite excluding food and energy, the core CPI is increasing. This means that inflation indeed is increasing and crude prices are not to be blamed entirely. This is a good sign for gold, which is used as a hedge against rising inflation.

Second point is the interest rate, which is still low if we take into account rising inflation. US 2-year Treasury yield is at 2.57 per cent, 5-year at 2.74 per cent and 10-year at 2.84 per cent. The 30-year US Treasury yield is at 2.97 per cent.

Yield curves are extremely flat right now and the 30-year yield is just delivering 24 basis points more over 5-year yield. This is remarkable that if one holds 30-year US government bond, they are getting just more 0.24 per cent per year than holding 5-year debt.

Also, if the inflation rate is over 2 per cent, what incentive investors will get in a return of 2.97 per cent for 30 years? This phenomenon could reduce demand for long-term US debt and the funds will eventually flow into other asset class like equity or gold.

The short-term 2-year US Treasury yield is at 2.57 per cent and US CPI at 2.8 per cent, which means bonds that are considered safe havens are giving negative real rate of return.

Third reason is there is less room for the US Fed to hike interest rate. Gold investors are forward looking. The Fed has so far hiked seven times interest rate since December 2015. It is now deep into tightening cycle.

Now, the US central bank has limited room as Fed funds rate now stands at 1.75-2 per cent. And the general consensus is that rate increase should be topped out around 2.9 per cent levels. This means there will be room for just four more hikes.

The ECB will start winding down its bond buying programme from December and may start to lift its interest rate from summer 2019. So, ECB will be starting to hike rates when the Fed will be running out of steam. This will be bullish for the euro and gold as well.

Despite numerous attempts, gold could not break out to new highs in April. Moreover, prices were further suppressed following the Feds rate hike in June. However, recently gold became significantly oversold, and is now trading slightly above its critical support.

In addition, the backdrop is still very constructive for gold, considering elevated inflation, low interest rates, a very high gold to silver ratio, an overextended dollar, and several other factors. Ultimately, it seems likely that gold is near a significant bottom here, should stabilise, rebound, and possibly move substantially higher into year-end and beyond.

(The author is Director, Tradebulls Securities.)

Original Article

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