Gold Poised to Return to Bull Trend

　　In the first half of 2022, gold prices remained firm despite a rising dollar, showing gold's role as a safe-haven amid inflation and geopolitical risks. However, the historically strong negative correlation between the U.S. dollar and gold was on full display in the third quarter. London cash prices began to slide in July, reaching a low of $1,614 by September. It is currently maintained at around $1766.

　　The decline in gold prices in the third quarter triggered demand for physical gold everywhere, but in the long run, many risks may drive gold prices higher and return them to the bull market trend that has existed since 2016.

Banks buy gold at record levels

　　Over the past period of time, the United States has continued to raise interest rates, and the 10-year U.S. Treasury yield has risen above 4% for the first time since 2008, but the dollar failed to hit a new high in October. The market is starting to wonder if interest rates have peaked, keeping gold prices above $1,600 an ounce.

　　Gold came under pressure from the dollar's continued strength, a result of the Federal Reserve's plans to raise interest rates and market expectations that it will succeed in curbing inflation.

　　Historically, when gold prices weaken, physical demand for gold in Asia and the Middle East rises. Current low gold prices are no exception, with buyers in China, India and the UAE seeing buying opportunities.

　　According to Bloomberg, gold in Dubai, Istanbul and Shanghai is trading at a premium to spot prices in London. Since April, more than 527 tons of gold have flowed out of vaults in New York and London, while Chinese imports hit a four-year high in August.

　　Demand from central banks is also strong. The World Gold Council reported that banks bought a record 399 tonnes of gold in the third quarter. This physical demand may allow gold to find a floor near current levels.

　　But historically, gold has had a strong negative correlation with real interest rates. If inflation remains at current levels (CPI growth in the US was 7.7% in October) or close to current levels, at a federal funds rate of 5% (assuming the Fed continues to raise interest rates to 5%), real interest rates will be negative, which means Will be good for gold. We expect gold prices to consolidate around $1650-1700 an ounce in the near term.

　　However, there are many reasons for gold to rise going forward.

Gold may return to bull trend

　　When it comes to exchange rates, many have been tracking the dizzying rise in the U.S. dollar and the fall in many other currencies around the world. The chart below shows the gold price in local currency.

　　The gray line is the price of gold in USD, while the green and blue lines represent the price of gold in GBP and JPY, respectively. Gold prices in local currencies periodically outperform or underperform dollar-denominated gold, but historically, the three prices tend to converge.

Different currency-denominated gold yields diverge

Data source: Bloomberg, data as of October 2022

　　But the rectangles in the chart highlight the recent notable divergence between dollar-denominated gold and gold denominated in the other two currencies. In fact, going back to 1972, there has never been such a difference. These exchange rate misalignments reflect the extraordinary risks facing the world today.

　　1) Geopolitical risks continue to escalate. The Heritage Foundation downgraded U.S. military power to Weak in its 2023 U.S. Military Strength Index due to shrinking shipbuilding, maintenance delays and backlogs, aging aircraft, pilot shortages, pilot training, ammunition stockpiles Low and insufficient recruits. The United States currently spends about 3% of GDP on defense, compared to 5%-6% in the 1980s.

　　2) Inflation remains high for a long time. Several recent indicators suggest that macro risks are also increasing. US CPl and PPl inflation continued to rise. In September, the CPI rose by 8.5% year-on-year (it has fallen back in October). According to a study by Deutsche Bank, since 1970, 126 observations worldwide have shown that when inflation exceeds 8%, it will remain above 2% for at least 4 years.

　　3) Recession risk intensifies. In a recent Wall Street Journal article, the managing director of the International Monetary Fund said that "a global recession is very likely". Economists see a 63% chance of a U.S. recession in the next 12 months, up from 49% in July.

　　4) There are two other areas of risk that have been overlooked in the market: debt and international currencies. Higher interest rates are making U.S. debt servicing the largest item in the U.S. federal budget. But this problem is not limited to the United States, and debt in many countries around the world continues to rise. And as existing debt is assigned higher interest rates, debt servicing will consume a larger proportion of global GDP. An April 2021 estimate of G7 interest payments in 2026 showed that few expected an increase in debt repayments. Debt risks could rise as more economies adopt tightening central bank policies.

　　5) Black swan events, such as the LDI crisis in the United Kingdom - the British pension fund has been using a liability-driven investment strategy (LDI), which caused a huge market shock, and the Bank of England rescued the market urgently.

　　We see all of these risks as potential catalysts that could push gold higher and return it to the bull trend that has been in place since 2016.

　　More recently, a pause in the Federal Reserve's tightening program could be a powerful catalyst for higher gold prices. However, when the market expects the end of rate hikes or believes that the Fed will no longer continue to control inflation, gold prices may even rise before the Fed pauses or adjusts policy.