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Lower rates make gold a more attractive investment
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The cost of owning gold drops
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Producers receive less for hedging future production
Gold has been one of the best-performing assets of 2019. The yellow metal has come a long way since the turn of this century when central banks were selling the precious metal. The United Kingdom sold half of its reserves, sending the price down to a low at around $250 per ounce. Canada also sold its reserves. However, the other central banks of the world did not follow. Some market participants argued that gold was nothing more than a barbarous relic of the past. They were wrong. In 2011, the price rose to a high of $1920.70 in dollar terms. In 2019, gold rose to new all-time highs in a host of currencies, including the euro, pound, yen, Australian and Canadian dollars, and many others. Central banks were selling in 2000 when the price was on its lows. These days, they have been net buyers of the yellow metal with Russia and China leading the way.
Global interest rates are falling, and that could mean that gold is poised to move even higher over the coming weeks and months. The SPDR Gold Shares ETF product (GLD) replicated the price action in the gold market.
Lower rates make gold a more attractive investment
Gold, like all other assets, competes with investment instruments for capital. As interest rates fall, bond prices rise, and the yield on fixed-income securities decline. Stocks traditionally move to the upside in a falling interest rate environment, and the same goes for gold.
Central banks hold currencies, gold, and other assets in their reserves. These days, many foreign exchange instruments provide historically low yields. The euro, yen, and Swiss francs all suffer from negative short-term rates, which causes depositors to lose capital. In the current environment, gold shines even more brightly than in the past.
The cost of owning gold drops
The forward curve or the term structure of the gold market reflects the cost of storage, insurance, and interest rates. When the latter are at historically low levels, the cost of financing a position or the opportunity cost of gold declines.
(Source: CQG)
The chart of the spread between gold for delivery in December 2020 and for delivery in December 2019 has been trending lower. In August 2018, the one-year differential traded at $54.50 when the price of gold was lower. In August 2018, the high in nearby gold futures was at $1223.70 per ounce. At over $1500 at the end of last week, the one-year differential was at $26.20 per ounce. The decline in the spread reflects the drop in the cost of holding a long investment or trading risk position in the gold market. A lower cost of carry tends to be bullish for the price of the precious metal.
Producers receive less for hedging future production
When the forward curve in the gold market declines and spreads narrow, producers receive a lower premium for hedging future production. Therefore, many producers do not have the same incentive to hedge their future output.
Interest rates have been at historically low levels for years in a host of currencies. Meanwhile, the US dollar is the world’s reserve currency. US dollar rates rose from December 2015 through the end of 2018. In June 2019, the US central bank told markets that short-term rates would decline by the end of the year. In late July, the Fed cut the short-term Fed Funds rate by 25 basis points for the first time in years. At the same time, the central bank ended its program of balance sheet normalization, which relieved the upside pressure on rates further out along the yield curve. In September, they cut rates by another one-quarter of one percent. At the latest FOMC meeting on October 30, the Fed delivered its third 25 basis point rate cut this year. At the same time, the European central bank cut interest rates by ten points in September and told markets they would begin purchasing debt securities in November. The bottom line is that falling rates around the globe have been highly supportive of the price of gold.
So long as rates continue to trend lower, the upward pressure on the price of gold should remain intact.
The SPDR Gold Shares (GLD) was trading at $140.25 per share on Wednesday morning, up $0.40 (+0.29%). Year-to-date, GLD has gained 13.42%, versus a 15.53% rise in the benchmark S&P 500 index during the same period.
GLD currently has an ETF Daily News SMART Grade of B (Buy), and is ranked #1 of 33 ETFs in the Precious Metals ETFs category.
About the Author: Andrew Hecht
Andrew Hecht is a sought-after commodity and futures trader, an options expert and analyst. He is a top ranked author on Seeking Alpha in various categories. Andy spent nearly 35 years on Wall Street, including two decades on the trading desk of Phillip Brothers, which became Salomon Brothers and ultimately part of Citigroup. Over the past decades, he has researched, structured and executed some of the largest trades ever made, involving massive quantities of precious metals and bulk commodities. Aside from contributing to a variety of sites, Andy is the Editor-in-Chief at Option Hotline.