Gold vs. U.S. dollar: What goes higher from here?

By: Ani Markova, MBA, LIFA, CIM, CFA • September 17, 2018 • Markets

In the battle of safe havens, gold has lost out to the rallying U.S. dollar in recent months, but a number of factors now at play could lead to a weaker greenback and put bullion back on top in the weeks ahead.

Down more than 10% since peaking in April, gold continues to face a number of challenges and has not benefited – as would normally be expected – from the escalation in global trade tensions of the past few months and economic sanctions imposed by the U.S. on Turkey, Iran, North Korea and Russia. In part, this stems from a growing confidence in the U.S. economy, which has bred a certain degree of complacency towards these apparent geopolitical risks. However, the recent weakness in gold primarily boils down to expectations of higher interest rates in the U.S. and strength in the U.S. dollar.

Having most recently hiked interest rates in June, the U.S. Federal Reserve has indicated its intention to increase rates by a total of four times in 2018, up from the three hikes previously communicated. Given the negative correlation between real interest rates and the price of gold, the Fed’s increasingly hawkish stance has heavily weighed on bullion. At the same time, the U.S dollar has continued to rise, not only from the prospect of higher rates, but also because of a flight to safety trade related to the White House’s central role in global trade negotiations with key allies.

This has contributed to the growing negative sentiment in gold with perhaps the most crowded trade this summer being long the U.S. dollar and short commodities and U.S. treasury bonds. Speculators have now gone to extreme short positions in gold, with total short positions reaching all-time highs and net positioning turning negative for the first time since December 2001.

Gold Net Non-Commercial Future Positions and Non-Commercial Short Futures

Gold Net
Source: Bloomberg (CEI1GNCN Index and CEI1GNCS Index), September 13, 2018

While this trade may still have legs given the current macro environment, there are some indications that the U.S. dollar could weaken in the weeks ahead and that gold could rally from its current doldrums as result.

For one, U.S. dollar bull markets tend to last no longer than six to seven years; and if we are still in a U.S. dollar bull market, this would be its unprecedented eighth year.

Dollar bull markets have tended to last 6-7 years

Dollar Bull Market
Source: Ned Davis Research

Second, there has been a historically broad relationship between twin U.S. deficits – a simultaneous budget and trade shortfall – and the value of the U.S. dollar. The U.S. twin deficit currently sits at 6% of U.S. GDP and is expected to widen to over 9% of U.S. GDP in 2019, according to IMF forecasts. Given that it usually takes a weaker currency to make exports more attractive and improve trade deficit conditions, this deterioration of the U.S. twin deficit could lead to a devaluation of the U.S. dollar.

Third, the economic divergence that we have seen since late 2017 between the U.S. and other countries has since eroded. This is highlighted by the spread of the Citi Economic Surprise Index of the U.S. vs. the G10, which has recently closed and moved to the downside, indicating that economic releases in the U.S. have surprised more to the downside relative to major economies. This underperformance can be expected to place additional pressure on the U.S. dollar if the spread continues to widen to the downside.

Spread between the U.S. and G10 economic surprise indices have turned

Spread between the U.S. and G10
Source: Bloomberg, Citi Economic Surprise Index, September 13, 2018.

Beyond these headwinds, U.S. President Trump’s recent remarks regarding the U.S. dollar could also potentially play into the future weakness of the greenback. In a mid-July interview, Trump broke protocol to express his concern that the U.S. dollar was “too strong,” and criticized the Fed’s pace of monetary tightening, particularly as China allows the yuan to weaken in a tactical effort to combat the adverse impact of tariffs on economic growth. While it remains unlikely, these comments raise the possibility of the U.S. turning toward a more interventionist currency policy as seen back in 2000 when it united with fellow members of the G7 to boost the sliding euro.

In such an event, a weaker greenback would likely be supportive of bullion. At the same time, prospects of a recovery in gold are supported by data that suggests a new cyclical bear market in stocks may have begun when the U.S. 10-year treasury yield hit a seven-year high on May 17th of this year. This marked the start of an economic cooling phase, according to Ned Davis research, and since then global equity market performance has been similar to the returns of prior cyclical bear markets (as defined by Ned Davis) that occurred in 2011 and 2015-2016, but also resulted in gains in gold of 19.3% and 3.6%, respectively.

U.S. mid-term elections are another potential catalyst for gold prices to rally higher – particularly if it leads to increased market volatility (see our note from January 2018) – while seasonal tendencies like Indian wedding season, which have historically dictated stronger demand throughout the fall months, could soon become an additional tailwind.

Ultimately, gold remains an important tool for currency hedging, portfolio diversification and wealth preservation in the current environment. In the near term, we believe prices could rise based on the potential for short covering, but a more sustained recovery will still depend largely on the U.S. dollar weakening, a slowdown in both U.S. and global growth and a subsequent increase in market volatility in the weeks ahead. With the S&P 500 Index now in its final innings of the longest bull market in history, it is not a matter of “if” but “when” the market will roll over – this is when gold will start to shine again and outperform the U.S. dollar.

The commentaries contained herein are provided as a general source of information based on information available as of September 13, 2018 and should not be considered as personal investment advice or an offer or solicitation to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication; however, accuracy cannot be guaranteed. Market conditions may change and the manager accepts no responsibility for individual investment decisions arising from the use of or reliance on the information contained herein. Any financial projections are based on the opinions of the portfolio managers and should not be considered as a forecast. The forward looking statements and opinions may be affected by changing economic circumstances and are subject to a number of uncertainties that may cause actual results to differ materially from those contemplated in the forward looking statements. The information contained in this commentary is designed to provide you with general information related to investment alternatives and strategies and is not intended to be comprehensive investment advice applicable to the circumstances of the individual. We strongly recommend you consult with a financial advisor prior to making any investment decisions.

References to specific securities are presented for illustrative purposes only and should not be considered as investment advice or recommendations. The specific securities identified and described herein should not be considered as an indication of how the portfolio of any investment vehicle is or will be invested, and it should not be assumed that investments in the securities identified were or will be profitable.

AGF Investments is a group of wholly owned subsidiaries of AGF Management Limited, a Canadian reporting issuer. The subsidiaries included in AGF Investments are AGF Investments Inc. (AGFI), AGF Investments America Inc. (AGFA), AGF Asset Management (Asia) Limited (AGF AM Asia) and AGF International Advisors Company Limited (AGFIA). AGFA is a registered advisor in the U.S. AGFI is registered as a portfolio manager across Canadian securities commissions. AGFIA is regulated by the Central Bank of Ireland and registered with the Australian Securities & Investments Commission. AGF AM Asia is registered as a portfolio manager in Singapore. The subsidiaries that form AGF Investments manage a variety of mandates comprised of equity, fixed income and balanced assets.

Publication date: September 17, 2018