As news of the escalation of the COVID-19 epidemic hit global financial markets this week, investors predictably ran towards safe havens such as gold and the US dollar. The dollar index moved towards the 100 mark and gold tried to get closer to the $1,700 level.
While the ongoing crisis has given a leg-up to the rally, the yellow metal has been on a dream-run since last calendar.
Factors such as protracted monetary easing and currency debasement by global central banks, extremely low to negative yield on bond prices and continued tensions caused by the ongoing anti-globalisation wave have pushed gold prices higher.
The coronavirus epidemic that has shaved off 0.1 percentage points from global growth in 2020 (according to the IMF), has only tilted the scales further in gold’s favour. Following the 15 per cent gain in 2019, gold has gained another 9 per cent this calendar year.
The interesting point to note here is that the gold prices are not being driven by actual investment demand for physical gold. The investment demand has been stagnant over the past decade. While gold ETF holdings moved higher in 2019, the demand for gold bars and coins had declined sharply in that period. A major part of the price increase in gold could be driven by trading and speculative positions.
Along with headlines regarding soaring gold prices, inflows into gold ETFs have also been attracting attention. According to the World Gold Council (WGC) , global gold ETFs and similar products added 61.7 tonnes to their holding in January 2020, taking the holdings of these investment vehicles to an all-time high of 2,947 tonnes. US funds hold nearly half of these ETFs with funds from the UK, Germany and Switzerland accounting for another 45 per cent.
Given the uncertainty over growth in these countries, investors could be trying to diversify some money into gold ETFs. If we consider the monthly inflows into these funds since 2018, inflows have spiked in months when there was negative news flow affecting global growth such as April 2018, December 2018, June and August 2019. Total additions to holding of gold ETFs in 2019 was 401.1 tonnes, the highest since 2016.
That said, it needs to be noted that the demand for physical gold bars and coins was down 25 and 8 per cent respectively in 2019 compared to 2018. Also, total investment demand for gold in 2019, at 1,271 tonnes, was unchanged from 2009, when similar amount was added by gold ETFs and gold coins and bars. There could have been a shift in investors preferring ETFs over physical gold bars and coins, probably due to heightened vigilance by anti-money laundering agencies. ETF demand has also picked up due to investors seeking to diversify their portfolios but investment demand for physical gold alone cannot be behind the recent rally.
Trading positions surge
So, what is driving gold prices? To answer the question, we need to look at the trading in gold derivatives. The open interest that captures all the derivative contracts not squared off by the end of the day gives a good idea of the trading interest in any security. The open interest in gold contracts traded on the Comex, Dubai, ICE, India, Istanbul, Moscow, SFE, TOCOM and LME is captured by the World Gold Council. This data shows that trading interest in gold was tepid in 2017 and 2018. But from January 2019, open interest began moving higher, from $68.7 billion in December 2018 to $141.8 billion in February 2020, the highest since January 2013.
It was around this time that interest in gold ETFs also began moving higher. A bulk of gold ETF purchase in 2019 was, in fact, done in the third quarter of 2019.
What changed in January 2019 that made traders move towards gold?
Gold and global uncertainty
It was in January 2019 that the Federal Reserve paused its rate hikes. This coupled with ratcheting-up of the US-China trade war heightened concerns regarding global growth. This seems to have prompted the surge in speculative demand in gold since the beginning of 2019.
The yellow metal has stayed true to its ‘safe haven’ status in most instances of global growth disruptions, if we consider the demand trend for gold over the last two decades. It may be recalled that global economic growth fell from 4.38 per cent in 2000 to 1.95 per cent in 2001, following the bursting of the dot.com bubble and the World Trade Centre bombing. Investment demand for gold spiked in 2001 to 357 tonnes, from 166 tonnes in 2000.
Similarly, during the global financial crisis in 2008, investment demand from physical coins and bars and gold ETFs, doubled to 1,184 tonnes compared to 2007.
The inverse relation between gold and interest rates is also fairly well established. The Federal Reserve decided to halt the rate hikes in January 2019 due to the threat of recession and began cutting rates in August 2019. Gold prices are up from $1,282 to $1,650 since the Fed began cutting rates last year.
The rally in gold prices from the October 2008 low of $723 per ounce to $1,825 per ounce in August 2011 also took place when the US had cut its interest rates close to zero following the sub-prime crisis.
It is widely believed that the negative bond yields in many developed economies such as Japan, France, Germany, Sweden and Switzerland are positive for gold since investors in search of yield are likely to move towards gold. Also, negative interest rates denote periods of economic stress, when the gold’s safe haven properties are most needed.
It is, therefore, obvious that the derivative prices of gold have moved higher in anticipation of increase in investment demand for gold following deteriorating global conditions. Given the logjam that global central bankers are currently in, unable to increase rates or do monetary tightening due to nebulous growth, the case for investing in gold is likely to remain strong over the next couple of years at least.
But if the investment demand for gold does not increase, mirroring the optimistic derivative prices, there could be sharp swings in prices in both directions. Investors in gold therefore need to stay alert for sudden bouts of volatility.