Is gold approaching a tipping point?

It is a property of physics that action is met by reaction, as a matter of real science. In the world of financial markets, however, that principle may only doubtfully apply, just as in economics cause and effect are very often difficult to disentangle.

That said, there is a fairly clear counterpart to the supposed likelihood of the US dollar rising with the expected onset of rising interest rates, as related last week. That is the impact on gold, responding both to the same underlying force and to the currency’s behaviour itself.

To begin with, it is a known phenomenon that to some extent gold and the dollar move in opposite directions as movement in the dollar exchange rate affects the price of the metal in other currencies, and therefore supply and demand (see box).

At the same time, as gold yields no income, the higher the yield differential in favour of the dollar, the lower becomes gold’s appeal. Moreover, higher interest rates imply restraint being exercised on inflation, whose effects gold is meant to guard against, again diminishing its relevance to the holder.

So there is a logic which says that gold should suffer upon the normalization of interest rates to levels at least modestly above the emergency provision of recent times. Gold should go into some kind of retreat.

Equally, if the world economy is in a middling sort of mode, threatening neither inflation nor deflation, then the safe-haven cachet is crimped as well. Subject to the outbreak of geopolitical concerns, which seem never very far away, it is in such circumstances that gold slips completely out of the reckoning as an investment asset, restricted only to a passing mention even in professional portfolios.

Of course, global conditions may not be quite so safe yet. First, there is a convincing argument (as made by the Bank for International Settlements — the central bank’s bank) that leading economies have essentially reflated the bubble preceding the crash of some six or seven years ago, so that another (perhaps worse) calamity could be in the offing. Second, the Euro zone in particular is clearly still exposed to the threat of debt overload, not growing sufficiently quickly to escape its hurtful dynamics, and therefore increasingly prone to attempting the kind of concerted monetary stimulus that put a rocket under gold when the US tried it.

With that uneasy background lurking in the imagination, it would not be so surprising if gold managed to maintain support, on the grounds of prudence in the face of economic history, and materially uncertain policymaking.

So what is gold actually doing now, and what signs are there of the reaction said to be due?

Notwithstanding intervening news events, notably from Ukraine, that have given temporary impetus, prices have dropped during the past five weeks, without much sign of inflationary strength in the global economy, and with variable requirements from traditional consumers India and China.

Meanwhile, for the moment at least, investors don’t seem inclined to relinquish their attachment to risk assets, especially equities, which have continued even higher upon a combination of the Federal Reserve’s accommodative policy bias and bullish economic numbers. They either don’t believe another catastrophic ‘Minsky moment’ of financial fallout is around the corner, or, finding inadequate reward elsewhere, they’re prepared to take their chances of steering clear of it at the last moment.

So gold may now be on the slide, as anticipated by analysts. Barclays, for instance, perceive a reason to be tactically underweight on commodities generally, “a function of our positive view on the US dollar and the likely negative impact on the space from looming [policy tightening] in the developed world.”

A sharp rebound might still be seen if stocks are eventually confronted with a shakeout. By contrast, if gold’s continued softness develops into a breach of technical support (such as at $1286), then a steeper drop might be in play.

As ever, it’s a fine balance, and a reminder that gold’s drivers are pretty febrile compared to mainstream investments.