Gold Prices: An Ominous Aura

Stubborn resistance to oxidation, unusual density, and ready malleability – these simple natural attributes explain all there is to the romance of gold.

Peter L. Bernstein, The Power of Gold: The History of an Obsession

Gold Prices and Market Foreknowing

Analysing the Implications of Recent Gold Price Spikes and What They Could Mean for Investors.

After remaining unchanged for the first two months of the year, gold prices in India spiked by 5.50 percent in the first two weeks of March 2024. As far as I know, over the past five years, such a sudden spike in gold prices has occurred on another two occasions. Both were accompanied or followed by events of grave concern. The major of the two occurred in May 2020 at the height of the pandemic when Indian gold prices rose sharply by 9 percent. The other one occurred in March 2023 when Indian gold prices spiked 5.00 percent, supposedly set off by the failure of Silicon Valley Bank in the US and Credit Suisse in Europe that put the global financial system on tenterhooks for a few days.

As we can see, an ominous aura surrounds a sudden spike in gold prices. Since gold is considered a safe haven, a sudden increase in uncertainty in the market or economy causes investors to rush towards the asset, triggering a sharp rise in its price. Since market prices tend to move beforehand, studying those price spikes could be instructive.

Normally, gold price changes are gradual. Therefore, a 5 percent gain in two weeks is very unusual and thus requires serious consideration. I searched news sources for any significant adverse development that coincides with the recent gold price spike – unfortunately, I couldn’t find any. Maybe the event is yet to transpire, and the spike in gold price might be an ominous sign for the oncoming event – market prices always had a knack for foreknowing. As gold is a global asset, the price spike is global too – in the US, a quick spike in treasury yields was attributed as the cause. But why did the yields spike? Of course, we know it signifies increasing risk aversion, however, we don’t know what those risks are. Perhaps it is unknowable, or maybe, we don’t have to – all we have to do is place our trust in the market’s foreknowing ability, and heed its advice, which is to turn risk averse.

Contrarian View on Gold Prices

The argument for a contrarian outlook on gold despite several tailwinds supporting a further rise in prices.

The past couple of years have been quite rewarding for gold investors. Indian gold prices have gained 15 percent annually over the past five years – keeping up with the equity market: Nifty50 has returned 15 percent in the same period. At the same time, gold price has exhibited commendable resilience during the period. It declined only once in 2021 that too in low single digit (-3.7 percent), while it made double-digit gains in four of the five years – the gains exceeded 20 percent in two years (2019 and 2020). As I find it, there is momentum in gold prices now, however, not as strong as they were three or four years ago.

Central banks have been increasing their gold reserves for some time, and there is no sign of a slowdown in the trend. Plus – the prevailing consensus is for interest rates to head downwards from the second half of this year, which will reduce the opportunity cost for holding gold. Moreover, the increasing ‘risk and uncertainty’ caused by escalating geopolitical tensions – Russia-Ukraine war, Israel-Palestine conflict, Houthi attack in the Red Sea – are tailwinds for gold prices.

Despite the prevalence of several factors supporting a further rise in gold prices, I have a contrarian outlook on gold. Gold prices have gained a lot over the past couple of years and now are at a point where the gain phase of the current cycle is about to be over. Therefore, now is not an appropriate time to buy gold from a return perspective. Returns will be sluggish for the next few years, during which, the prices will revert to their historical trendline. Making such a statement now – when gold prices are at an all-time high alongside several factors supportive of further price rise – might seem ridiculous. The outlook occurred to me as an intuition. Although intuition has merits, basing decisions solely on a person’s intuition is foolhardy. So, I better have a reasonable explanation that corroborates my intuition. But before going into that, we need to understand what causes gold prices to increase or decline.

According to Juan Carlos Artigas, Head of Research at the World Gold Council:

Gold responds to four factors and how they relate to each other: economic expansion, risk and uncertainty, opportunity costs, and momentum. Economic expansion refers to the fact that gold is not just an investment and long-term savings vehicle. As mentioned, it is also an asset that is bought as jewellery or used in electronics. So positive economic growth can have a positive effect on gold demand. Conversely, economic contraction can dampen economic demand, putting downward pressure on the price.

Risk and uncertainty as well as opportunity costs are two drivers that most people are familiar with when it comes to gold: As risk increases, people tend to invest more in gold and vice versa. Opportunity cost basically means that if interest rates increase, it gets more expensive to hold gold. The opposite happens when interest rates fall; holding gold becomes relatively more appealing. Finally, momentum can amplify these trends. If gold is already rising, positive sentiment can push prices even higher. Conversely, a downward trend can be exacerbated by negative momentum.

One reason for my dull outlook for gold prices is ‘regression to mean’. Historically, Indian gold has returned 11 percent annually. However, the current return run rate of gold, at 15 percent, is above that historical trend and has been so for the past 4 to 5 years. This divergence is unsustainable in the long run; the returns must revert to their long-term trend, and that reversion is expected to play out in the coming few years – during which gold prices are expected to underperform.

Another reason is that asset prices in financial markets mostly move beforehand. In other words, prices start reflecting the impact of any impending event even before the event materialises in real-time. Earlier, we discussed various factors favouring further gold price rise, such as central bank purchases, anticipated interest rate decline, and escalating geopolitical tensions. But these factors have been existing for some time, so any likely impact on prices by them might already be incorporated into the current gold price. Any incremental impact on gold prices from these factors might be little to none.

The current consensus in the market is that the US Fed with start cutting rates sometime this year. The Fed had indicated so in its Dec. 2023 meeting. Earlier the cut was expected to happen in Mar. 2024, but it didn’t because the Fed wants to wait to ensure that inflation was fully anchored. Now the consensus is for the rate cut to happen in June 2024. But the rate cut hopes could be dashed if inflation, which many consider to be subdued, revives. Then, the Fed might be forced to raise rates to contain inflation rather than cutting rates. If alongside the rise in inflation, the anticipated economic slowdown (soft landing) or recession (hard landing) arrives – the economy and markets will find themselves in a very precarious position. Both economic contraction and rising rates are unfavourable for gold prices. Perhaps such a scenario could be the catalyst that triggers a reversal in the current rising trend of gold prices.

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