Deflationary fears a bad omen for gold - Capital Economics
Metals

Deflationary fears a bad omen for gold

Precious Metals Update
Written by Alexander Kozul-Wright
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Fire sales of gold have seemingly given way to safe-haven buying following yesterday’s unprecedented intervention by the Federal Reserve. Providing the Fed has injected sufficient liquidity to defend against a further collapse in equity prices, we expect the gold price to tread water. That said, the possibility of a deflationary cycle poses a major downside risk to our forecast.

  • Fire sales of gold have seemingly given way to safe-haven buying following yesterday’s unprecedented intervention by the Federal Reserve. Providing the Fed has injected sufficient liquidity to defend against a further collapse in equity prices, we expect the gold price to tread water. That said, the possibility of a deflationary cycle poses a major downside risk to our forecast.
  • As expected, concerns about the financial fallout from COVID-19 initially boosted the price of gold. However, from late-February until this week, the price of gold fell even as equities collapsed and central banks around the world slashed interest rates. One possible explanation is that gold suffered from forced selling, where investors seek cash to cover losses on less liquid investments. Indeed, there are historical precedents for this.
  • When Lehman Brothers filed for bankruptcy on 15th September 2008, the gold price initially surged. Gold then went into freefall for for 6 weeks (as investors dumped liquid assets) before trending up thereafter. (See Chart 1.) Admittedly, the current virus-induced shock is very different to the global financial crisis. However, just as in 2008, central bank support should lead to a resumption of safe-haven buying and an end to distressed selling. (See our Precious Metals Update.)
  • Still, worries that the current crisis may result in a period of deflation pose a bigger threat to the gold market. The 2-year inflation compensation in US bond markets recently pitched into negative territory (see Chart 2), a sign that investors are concerned about deflation. That said, longer-dated inflation compensation remains positive, suggesting that investors remain sanguine about an extended deflationary cycle.
  • Given that nominal interest rates have almost reached their effective lower bound, further falls in expected inflation should raise the yields (and lower the prices) of real assets, such as gold. In contrast, other safe havens with fixed nominal coupon payments, like US Treasuries, may become more attractive. (See our Global Markets Focus.) In short, demand for gold may taper off if investors display growing concern about a deflationary spiral.
  • To be clear, we are not there yet. There is probably still some wiggle room for nominal interest rates to fall and, as mentioned previously, investors don’t yet seem to be pricing in a protracted period of deflation. But that could all change before long.
  • To sum up, we think that the price of gold will trend sideways this year, as near-term safe-haven buying eventually gives way to a gradual turnaround in global growth. Our end-2020 gold price forecast is $1,600 per ounce. However, if fears about a deflationary spiral gain traction, the gold price could fall.

Chart 1: Gold Price (US$ per Ounce)

Chart 2: US 2-Year Inflation Compensation (%)

Sources: Refinitiv, Capital Economics

Sources: Refinitv, Capital Economics


Alexander Kozul-Wright, Commodities Economist, alexander.kozul-wright@capitaleconomics.com

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