Five Reasons To Buy The Dip In Gold’s Price

Five Reasons To Buy The Dip In Gold’s Price
Stéphane Renevier, CFA

almost 3 years ago4 mins

What’s going on here?

It may have hit a new all-time high in August last year – but the price of gold has since fallen 17% in the space of eight months. I thought I’d take a look at why that’s happened – and why this recent pullback could present an intriguing buying opportunity.

What does this mean?

Gold prices are mostly driven by five main factors:

1️⃣ Nominal bond yields (falling = better)

Unlike stocks and bonds, gold doesn’t provide investors with any income. It therefore comes with an opportunity cost – and the higher the potential returns you’re missing out on, the less attractive gold looks relative to those investments. On the other hand, negative bond yields make gold look good: receiving no interest is better than paying someone else to lend them your money.

The recent sharp rebound in bond yields may therefore bear some responsibility for gold’s decline. But have yields risen too far, too fast? I suspect that may well be the case – and any imminent pause in the rally would be positive for gold prices.

US government bond yields have shot up in recent months (Source: MacroOps, Bloomberg)
US government bond yields have shot up in recent months (Source: MacroOps, Bloomberg)

2️⃣ Inflation (rising = better)

While the relationship between gold prices and inflation isn’t always linear, the shiny metal tends to do well when prices are rising fast: it’s particularly attractive as a store of value when high inflation is eroding currencies’ buying power.

But while investors’ inflation expectations have been increasing recently, gold’s price has failed to recover. That’s because those expectations are still lagging increases in nominal bond yields – and “real” yields (i.e. nominal yields accounting for the negative effect of inflation) are what really matter for gold prices.

Going forward, however, I think inflation is likely to increase more than nominal bond yields – and I’d therefore expect real yields to fall. In my view, the combination of yet more massive economic stimulus, pent-up demand, and the US central bank’s willingness to let inflation overshoot in the short term create the perfect cocktail for lower real yields – and higher gold prices as a result.

Gold’s price (black), real yields (purple), and the US dollar (yellow) (Source: Bloomberg)
Gold’s price (black), real yields (purple), and the US dollar (yellow) (Source: Bloomberg)

3️⃣ The US dollar (falling = better)

When the US dollar’s value depreciates relative to other currencies, gold’s price (which is quoted in dollar terms) typically rises as the metal becomes cheaper to overseas buyers. What’s more, when investors expect the world’s reserve currency to lose some of its value, they’ll often seek to stash their cash elsewhere, and gold makes an attractive alternative.

It’s therefore no surprise that gold has historically made its strongest gains during periods when the US dollar’s value was waning. And that’s my long-term view for the future – given, among other things, the American government’s particularly heavy borrowing.

4️⃣ Safe-haven flows (risk-off = better)

Whether it’s geopolitical turmoil or financial meltdown, gold is often seen as a safe haven in times of potential crisis. With investors currently happy to take big risks and flashy bets such as tech stocks and bitcoin competing for their attention, it’s perhaps no surprise that gold’s lost some of its shine. But while outflows have accelerated since the beginning of the year, we’re only one quick correction away from investors rushing back into old faithful’s metallic embrace.

5️⃣ Physical demand (increasing = better)

It’s easy to forget that gold has many real-life uses, particularly in the jewelry and technology sectors (read more here). As the chart below shows demand here generally increases when prices are falling – and so this could soon prove to be a supporting factor. While these fundamental factors are important, however, I think that the macroeconomic movements detailed above are likely to play a bigger role in determining gold prices in the current environment.

Gold demand

Why should I care?

Gold’s role as an investment is often misunderstood, perhaps thanks to the numerous and often contradictory factors influencing its price. By taking the time to understand these in more detail, you’ll be much better able to make sense of what’s happening with gold prices – and even identify interesting trading opportunities.

At this point in time, my view is that the stars are aligning nicely for gold prices to once again push higher. Of course, investing is a probability game – and it’s possible that gold prices could continue to go lower should bond yields and interest rates keep rising faster than inflation expectations. But for me, the balance of probabilities makes buying gold now an intriguing asymmetric bet after the big pullback of the past few months.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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