Key question: Is gold’s rally far from over?

Gold has had a great year, but is that strong run higher now over?

After all, there are strong downsides to owning gold that can discourage investors. Unlike stocks and shares, gold has no dividend for holding it. Unlike a bond, it has no yield either. In fact, holding gold physically can even incur storage costs. These costs add up over time and can be a disincentive to investors. However, the usual downside to holding gold has been offset this year by gold offering a store of value in the uncertainty that has been prompted by Covid-19.

Gold has been one of the standout performers over 2020, rising from around $1,515 an ounce to as high as $2,075 an ounce in August. Looking at the daily price chart below you can see just how strong gold’s move higher has been.

So, should we now consider this gold run complete or is there more upside to come after gold’s recent falls? In answering that question, we need to ask ourselves what factors caused gold’s strong move higher this year.

Why has gold moved so much higher in 2020?

Let’s look at three key factors underpinning gold’s rise this year:

#1 – Central banks using more quantitative easing

Firstly, central banks around the world have been embarking on a series of quantitative easing programmes. This weakens the value of currencies and increases the appeal of gold.

Quantitative easing (also known as QE, easy money or asset purchases) is a mechanism by which central banks boost money directly into their economies; many central banks use QE as a way of helping their economies. Money can be physical, like the banknotes in our pockets, or it can be digital like the money in our bank accounts.

QE is simply digital money which is then used by central banks to purchase things like government debt in the form of bonds. The impact of this for businesses is that it keeps borrowing costs low. When borrowing costs are low, this provides a good environment for businesses to expand; it is a stimulative environment for businesses. In normal times, central banks would achieve this by cutting interest rates. However, many central banks have already cut interest rates close to zero per cent.

The Bank of England, for example, has cut rates all the way down from 5 per cent to only 0.10 per cent at the time of writing.

So, the way to help the economy when rates are very low is by expanding the amount of QE. The Bank of England has recently expanded its QE purchases from $200bn to $745bn during the present coronavirus pandemic. All of this further ‘dilutes’ the value of currencies.

The US Federal Reserve, the world’s most influential central bank, has this year embarked on a programme of virtually unlimited QE to do ‘whatever it takes’ to support the US economy. As large-scale purchases of government bonds are made using the money from QE, the interest rates, or ‘yields’, on government bonds fall. This keeps interest rates low and stimulates the economy.

However, one of the unintended consequences of QE is that it also boosts the appeal of gold. This means that as interest rates around the world are kept low, it is far less attractive for investors to stay in cash. One chart that shows this relationship in action is the gold chart with the real yields of US 10-year bonds overlaid. The real yield is simply the yield of a 10-year US bond when inflation is taken into account. You can clearly observe that as real yields fall, gold prices have risen:

As long as US 10yr bonds remain pressured, this dynamic is supportive of ongoing higher gold prices.

How low interest rates support gold prices?

Another aspect that has supported gold prices is that central banks around the world have very low interest rates. Very low global interest rates mean that it is less attractive for investors to stay in cash. Gold is just more attractive in a low-interest rate world, especially when inflation rises. Secondly, some money managers project poor expected returns in equity markets as prices are seen as too elevated compared to earnings potential. Many longer-term investors are concerned that Covid-19 is going to hinder economic recovery for the medium term and drag down equity markets. This further adds to gold’s appeal as an alternative place of value.

#2 – The Federal Reserve’s recent monetary policy supports gold

At their last rate meeting in mid-September, the Federal Reserve kept interest rates unchanged and near zero, and indicated that they would stay there for at least three years, into 2023. It also cautioned that the pace of economic activity would likely slow after ‘the recovery has progressed more quickly than generally expected’. A low-interest-rate environment is supportive of higher gold prices and helps keep the USD weaker over the medium term. There are no rate hikes due from the world’s most influential bank and that should keep interest rates low for the foreseeable future, supporting the case for medium-term gold buyers.

#3 – Exchange-traded funds show record levels of gold demand

Gold has become very popular; there are now record holdings in gold ETFs. In the first half of the year, inflows surpassed the 2009 annual record of 656 tonnes and lifted global holdings to all-time highs of 3,621 tonnes. Current year-to-date gold ETF inflows have surpassed the largest annual gain of 646 tonnes seen in 2009 by nearly 50 per cent.

North American funds currently represent around two-thirds of global holdings, according to the World Gold Hub Council. Investors around the world are wanting to convert cash into gold in a bid to find a place of value in the present economic environment.

Where will the top in gold be? Can gold reach $2300 by year-end?

Of course, it is impossible to call a top in any market with certainty, but the fundamental conditions for gold mean that more upside is favoured over the rest of the year as long as market conditions remain as they are now. Goldman Sachs project that gold will hit $2,300 in the next year, driven by the rock-bottom interest rates.

What is the bearish case for gold?

So, the fundamental factors for gold buyers remain in place.

However, how will we recognise when the bull market has come to an end? The first major indication that gold’s bull run has come to an end will be rising interest rates from central banks around the world led by the Federal Reserve. This would likely come on a return to normal economies following an effective Covid-19 treatment or vaccine. This would be the major clue to stop buying gold on the dips lower and instead to start considering selling it on the rallies higher.

Until then, the recent dips in gold prices should find buyers.

Giles Coghlan is the chief currency analyst at HYCM