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The US dollar, which has been the hero of the Covid-19 crisis, came under a decent selling pressure from mid-March and tumbled more than 8% into the end of July.
The unprecedented monetary and fiscal stimulus has been the major catalyzer of the US dollar slide, as rising government debt and the excess cheap liquidity in the financial markets brought forward the risk of a serious surge in medium term inflation. Worse, if the US policies don’t translate into improved economic fundamentals, the world’s biggest economy could also face a period of stagflation – high inflation and high unemployment.
The fear of rising inflationary pressures is also what fuels the gold markets. The foundations of the gold rally have been laid in mid-2018 when the trade war between the US and China began boosting the prospects of a dovish shift in the Federal Reserve (Fed) policy.
At that time, the Fed was normalizing its rate policy. The Fed funds rate rose 225 basis points from 0.25% to 2.5% from 2016 to end-2018. The US interest rates stagnated in the first half of 2019. Then began the slide, which has accelerated in 2020 with the Covid-19 pandemic.
An ounce of gold was exchanged near $1150 in August 2018 and the price surged past $1500 within the following year. Investors’ interest in gold accelerated as the Fed began trimming interest rates. By March 2020, the US rates hit zero, unlocking the potential for the gold’s rally towards the $2000 per oz. The move was predicted by major banks including Goldman Sachs and Citigroup, and came as no big surprise.
Could the gold rally persist?
There are solid factors that could support and enhance the actual gold rally.
First, gold has proved to be an efficient hedge against inflation over the long term. And even if the inflation expectations remain low, the Fed’s ultra-lose monetary policy continue dragging the sovereign yields to such low levels that even the slightest inflationary pressure would push the real rates to the negative territory, if they are not there yet.
Second, as mentioned earlier in this article, there is a stronger case for a rapid surge in inflation following the Covid-19 crisis as the global demand picks up. If this is the case, investors will be increasingly tempted to replace their low, negative yielding treasury holdings with better yielding investment instruments. In this case, investors have a choice. Either they move capital towards risky equity markets – knowing that there is a serious decoupling between the actual share prices and the underlying company fundamentals which bear the risk of a sharp downside correction in case of a renewed risk sell-off across the globe. Or to pile into gold, which is not only an established safe haven, but should also provide a powerful protection against the rising inflation, and deteriorating micro and macro fundamentals.
Third, even though gold is a non-interest-bearing asset, the low sovereign yields provide an almost inconsequential cost of opportunity for investing and holding gold. The latter is an additional motivation for gold investors to sit on their existing holdings and strengthen their long positions.
Finally, the sharp decline in the appetite for US dollar, which has acted as the ultimate refuge during the Covid-19 sell-off and has even outperformed gold, cleared the path for further gains in the yellow metal. As long as the rising US government debt, the risk of a ‘capital war’ between the US and China, the prospects of uncontrollable rise in inflation and the ultra-loose Fed policy weigh on the greenback, gold will offer a solid alternative for investors looking for value storage.
Consequently, the unprecedented monetary and fiscal support, and the expectation of more stimulus could keep the dollar on a falling and gold on a rising path. If this is the case, gold could consolidate and even extend gains above the $2000 per oz.
In the short run however, the accumulation of long speculative positions in gold could drag the prices abruptly lower. A sudden profit taking in non-commercial positions is therefore a risk that investors should consider at the current levels. But price retreats could offer interesting dip-buying opportunities for medium to long term investors looking to take advantage of the unique benefits of holding gold in such hectic economic and financial conditions.