While inflation is finally falling, recent forecasts released by the IMF show that global growth is expected to decrease from 3.4% in 2022 to just 2.8% in 2023, primarily due to the upward trend of interest rates since December 2021.
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As such, with central banks now balancing elevated prices with low growth, there is a significant amount of volatility in the markets, which is encouraging investors to protect their portfolios with gold.
Consequently, prices have skyrocketed by around 10% since 2022 and could reach new heights in 2023. So, what causes the price of gold to inflate, and what factors are behind the recent rally?
What causes gold prices to inflate?
The link between gold and its principal price determinants is intricate, yet there are general patterns that investors should bear in mind in a volatile economy.
Firstly, gold prices are dollar-denominated, so prices have an inverse correlation with the USD. This means that a weaker USD tends to bolster gold prices, while a stronger USD hampers its upside potential. This is because when the value of the dollar is low, investors holding foreign currencies can acquire gold at a relatively cheaper price, which drives up demand and ultimately, prices.
Similarly, gold has a comparable relationship with real yields, which refer to the returns on a bond that remain after adjusting for inflation.
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Consequently, when real yields decrease (implying that the returns from a bond are close to zero or negative), investors to turn to gold as an alternative investment that can generate returns in an inflationary climate.
Finally, a notable development in recent months has been the surge in demand for gold by central banks, which augment their gold reserves during inflationary periods.
Like investors, central banks turn to gold because of its inherent value as a finite resource, meaning that that it can maintain the value of a bank's reserves, even as the prices rise elsewhere. Thus, central banks can substantially fuel the demand for gold, driving up prices as well.
What factors explain the recent rally?
The recent uptick in gold prices can be attributed, in part, to the shifting outlook for interest rates.
Most central banks have been actively pursuing a policy of aggressive interest rate hikes in the last year, but many are now indicating that they are nearing the end of their cycles. As a result, gold prices have experienced an upward surge, since the likelihood of further interest rate hikes has declined.
The significance of central bank policy in shaping gold prices was aptly highlighted on 13 April, when the US markets signalled a 70% probability of another rate hike by the Federal Reserve in May, and the possibility of a rate cut by July rose to 56%. In response, gold futures reached their highest point so far in 2023, hitting $2,056.15 on 14 April.
Elsewhere, the increase in gold prices has also been driven by increasing apprehension among investors about the likelihood of recession.
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As interest rates continue to stifle economic growth, several investors have sought the safety of gold as a hedge against potential stock market declines.
So the likelihood of further rate hikes increases, or if growth remains feeble, this trend could gain further traction.
Meanwhile, the US dollar has declined by 1.35% since the start of the year owing to the increasing likelihood that the Fed will halt its rate hiking cycle.
Consequently, gold has become less expensive for holders of other currencies, resulting in a surge in demand and pushing prices up.
Lastly, the recent failures of SVB and Credit Suisse have caused alarm about the stability of the banking system, contributing to an increase in gold prices. As apprehensions about banking contagion escalated, gold prices soared by over 2% in March, marking the largest weekly increase since November 2022.
Could gold hit new heights?
To conclude, amid mounting concerns over a recession and stock market valuations, several analysts are forecasting that gold will reach all-time highs in 2023. If banks opt for a more dovish approach to interest rates to protect economic growth, therefore, gold prices could increase by over 20%.
Meanwhile, a decrease in interest rates is likely to result in sustained weakness in the dollar, and with inflation still prevalent, investors seeking to hedge are expected to continue to drive demand for gold.
This trend could persist throughout Q2 2023, potentially propelling the price of the yellow metal to unprecedented levels.
However, the path of US rates, global growth expectations and inflation levels are all highly variable factors, so significant risks remain at the moment.
Stavros Lambouris is CEO at HYCM International