The turmoil in emerging markets and the softer US data have taken the bullish edge of markets and have shifted in the near-term investment thesis for both bonds and gold.
But it hasn't changed the USD too much on a trade weighted basis, which has been fairly stable, particularly relative to other periods of turmoil.
Gold is also looking pretty well behaved relative to the dollar, staying within its recent range. This is in stark contrast to the big drop seen last year, where gold gapped downwards as the currency stayed firm.
Combining both US real interest rates and the USD TWI as explanatory variables of gold in a linear regression continues to show that the investment thesis for gold is still overwhelmingly about whatever is driving broader markets rather than gold-specific demand/supply dynamics.
The modelled estimates in the chart on the left are based on outcomes of a linear regression on daily data from 2009 to the end of 2012. So the fact that this model still works pretty well over a year later suggests the investment framework for gold hasn't changed much, notwithstanding the massive change in physical consumption flows.
There have been two periods in the last 12 months, as circled in orange on the chart on the left.
These two periods are not so much to do with something gold-specific, but rather an apparent difference in investment views between those holding gold and the much larger, more liquid bond market. In particular, it appeared to do with the possibility of tapering of asset purchases by the Fed.
Since September, there hasn't been any notable divergences between gold, bonds and FX markets. I think it would be a mistake to believe the recent rally in gold has something to do with better physical demand or a changed profile from ETFs, as that may suggest the rally could continue even if bonds sell off. Really gold is moving in concert with other key variables and there is nothing to suggest at this stage that it won't continue to do so.
So when asking the question of what is next for gold, in many ways its asking what is next for bonds and the USD. I would argue most investors have a better comprehension of what moves bond yields than the gold price.
For yields to drop further, we would probably have to see a reversal in the current path for monetary policy set out by the FOMC. For that to happen we would probably have to see a material drop in inflation expectations, which on a 5-year basis are tracking around 1.7%.
In the first instance, a drop in inflation expectations might not be bullish for gold, which is driven more by REAL interest rates. But ultimately the Fed would look to recreate real yields seen in 2013 via aggressive policy, which would probably see gold rally quite a bit.
At this stage, the risk of this happening is fairly low given growth in the US is looking better than it has done for the last few years. On that basis I wouldn't be betting on gold rallying much further.
