Thought November 01, 2018 / 03:11 pm UTC

Gold Price Rally Needs a USD Peak

By Mike Gallagher

Global central banks' gold-buying interest increased in Q3 2018 with India, Poland and Hungary joining the usual suspects Russia, Turkey and Kazakhstan, according to the World Gold Council. A sustained rally in gold prices, however, requires a USD peak and this will likely not occur until Q2/Q3 2019. 

One driver of central banks' gold purchases is diversification from USD, both due to its currently-elevated level as well as a less-friendly and more volatile U.S. administration (a big motivation for Russia). If the U.S. House of Representatives switches to a Democrat majority, as expected, President Donald Trump will have to spend more time on foreign policy, heralding more geopolitical tensions. 

Interestingly, China remains absent among the central banks buying gold, having stopped its purchases after the decline in FX reserves to $3 trillion through 2014-16. With a narrowing current account surplus, we believe China is not really in a position to rebuild FX reserves, which is a precondition to restart China’s gold purchases anyway. 

For gold prices, the pick-up in central banks' demand needs to be watched in the coming quarters. Additionally, the hedge fund and commodity trading community's large short position also remains vulnerable to a squeeze in 2019. 

The most critical issue for gold prices is the likely peak in USD on a multi-quarter view. The inverse correlation of gold prices with the USD index is well-known—we look at the broad USD index from the Fed, rather than the narrow DXY of G10 currencies (Figure 1). The U.S. money and bond markets, however, are discounting only two Fed hikes in 2019 rather than the three that we forecast. In our view, a sustained gold rally can only occur when three hikes are discounted and the USD is clearly seen to have peaked—likely in Q2/Q3 2019. 

Figure 1: Inverse Correlation Between USD Index and Gold ($)

Source: Continuum Economics

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I, Mike Gallagher, the lead analyst certify that the views expressed herein are mine and are clear, fair and not misleading at the time of publication. They have not been influenced by any relationship, either a personal relationship of mine or a relationship of the firm, to any entity described or referred to herein nor to any client of Continuum Economics nor has any inducement been received in relation to those views. I further certify that in the preparation and publication of this report I have at all times followed all relevant Continuum Economics compliance protocols including those reasonably seeking to prevent the receipt or misuse of material non-public information.