The 'never-ending' slide in gold

By David Morrison  |  14/08/2018 14:59

The dramatic sell-off in the Turkish lira and other emerging market currencies has raised concerns about contagion. But investors continue to spurn gold as the traditional ‘safe-haven’

Just two months ago gold was trading above $1,300 having pulled back from the $1,365 level (close to a 21-month high) hit in April. Today it broke below $1,200 to trade at its lowest level since January 2017. This 12% April-August sell-off corresponds to a 7.7% rally in the US Dollar Index over the same period and this goes a long way to explain investors’ reluctance to buy gold, in dollar terms at least.

Emerging market woes

But many would argue that this can’t be the whole story. When one considers the political landscape with the Turkish lira in near free-fall (although it has rallied a touch today) and the ongoing sell-off in other emerging market currencies (the Argentine peso, Brazilian real and South African rand to name just three) then it would seem reasonable that investors would want to diversify just a little bit and include some gold in their portfolios. The argument for owning gold is strengthened when one considers that the major US stock indices are trading close to all-time highs and may not offer the best returns going forward. Add in the Trump administration’s trade tariffs aimed at China and once again the old school view that gold offers protection in times of uncertainty should bear some consideration at least. But it’s just not happening. Gold is being spurned as a traditional safe-haven and ironically, it could be tariffs themselves which are weighing on the price.

Tariff tit-for-tat

Specific US tariffs on Chinese imports were announced at the beginning of this year. Despite this, the Chinese yuan continued to strengthen versus the dollar. But this turned out to be the last few weeks of a rally which had begun the year before and was really a weak-dollar story. Over the next 10 weeks the USDCNY traded sideways as the tit-for-tat tariff rhetoric ramped up. Then the US dollar rallied sharply in a move which has seen the yuan lose the best part of 10% to where we are today. It’s probably no coincidence that gold has lost a similar percentage over the same period. The theory is that China is informally pegging its currency to gold, setting the stage to challenge the dollar’s reserve currency role sometime in the future. Of course, that 10% fall in the yuan pretty much counters Trump’s 10% tariffs – currently set on the best part of the $50 billion-worth of Chinese exports to the US. The question is what happens if Trump goes ahead with his threat of upping tariffs to 25% and applying then to $200 billion worth of Chinese goods? Would China respond in kind and watch their currency fall by a commensurate percentage? A sharp 25%-yuan devaluation would cause market devastation. Bearing in mind the USDCNY is less than 2% below 7.00, a level some consider a red line when it comes to exacerbating an already dangerous stand-off between the US and China, then a move to 7.50 or beyond seems unlikely. Nevertheless, it’s difficult to see which country will blink first if this trade war hots up further.

The US dollar

Considering the US dollar, there are increasing concerns that the world is facing a shortage of its reserve currency. For a start, the US Federal Reserve is the one developed-world central bank that is actively tightening monetary policy. It is pushing up interest rates, thereby making the dollar attractive to foreign investment and so increasing demand. It is also reducing the size of its balance sheet as it no longer reinvests the proceeds of maturing bonds. Crudely put, when the Fed engaged in quantitative easing it bought US Treasuries and mortgage-backed bonds with dollars printed by the Treasury which added to dollar liquidity. Now that process is being reversed, while investors in emerging markets are dumping these currencies and buying greenbacks.

Looking for a crisis

On this basis, the outlook for gold doesn’t look great. But on the flip side it’s looking oversold and there have been times in the past, given certain conditions, that gold and the dollar have been positively correlated. Typically, this is in times of real financial crisis. It could be that a panic in emerging markets spreads to European and US banks. Or that an escalation in the trade war beyond a certain point leads to a sharp correction in US equities. We could see the US Treasury yield curve resume its flattening if third quarter economic data indicates we’ve seen the peak in economic growth and corporate earnings. But for now, gold bulls will be happy enough if prices would just stop falling.


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