Hawkish Fed, sluggish dollar, and a China gold bug

The People’s Bank of China (PBOC) announced it purchased 32 tonnes of gold in November. This is the first official purchase by the PBOC since 2019. In the past, PBOC had purchased consistently for many months between long periods of inactivity. More purchases in December could indicate consistent buying from China in 2023, which could bode well for the gold market.

The gold miners were quiet in December. The NYSE Arca Gold Miners Index fell 0.14%.

Gold in 2022: It’s been a wild ride

For the year, the gold price finished with a loss of just US$5.18. While gold ended nearly unchanged, the year was far from calm, with prices dropping US$450 from highs to lows before returning to its starting point. Gold saw a maximum drawdown of 11.3% but finished with just a 0.3% loss, which was a respectable result, given the 18.1% loss for the S&P 500 Index and 64.3% loss for bitcoin.

“War premium”

Gold had been trading in a range centered on US$1,800 for most of 2021. It broke out in February 2022 as warnings surfaced of a possible attack on Ukraine. However, once Russia’s bombing of Ukraine began, gold went on to test its all-time highs on March 8 at US$2,070 per ounce. By May, the war premium had faded as it became clear that the fighting was not likely to escalate beyond Ukraine.

Dollar strength

The war provided a temporary positive catalyst. However, the dominant driver through most of the year was increasing pressure on gold prices from Fed policies and the US dollar. The market underestimated the resolve of the Fed to fight inflation. In January 2022, interest rate futures were pricing a 0.77% increase in Fed Funds rates by the end of the year. By April 2022, markets were pricing in at least 1.5% in further rate increases. However, Fed Chairman Jerome Powell continued to take a tough stance on inflation, and the Fed increased interest rates by 4.25%, in one of the sharpest raises in history. The war, the rise in rates, and the relative strength of the US economy contributed to the relentless strength in the US dollar, which made new 20-year highs continue from May to September.

The inverse correlation between gold and the US dollar is well established. Real rates and tail risks also influence gold's performance. However, until 2022, we hadn’t realised how dominant of a driver the US dollar could be. The great gold bull markets of the 1970s and 2000s were driven by inflation and the dot-com bust/financial crisis, respectively. Each of these also coincided with a secular bear market for the US dollar. While we believe current tail risks which include the pandemic, inflation, war, are as severe as those in past bull markets, the key difference in 2022 was the strong US dollar. This kept the pressure on gold prices, muting the response from inflation, geopolitical turmoil, and other risks.

Physical demand support

Amid US dollar strength, gold trended to US$1,614 on September 28—its low for the year. Technically, gold was poised to trend as low as US$1,400. However, gold prices found support from physical demand in India and China, while retail bar and coin demand was strong in the US and Germany. In addition, central banks bought record amounts in the third quarter, led by Uzbekistan, Qatar, and India. Gold tested its US$1,614 low several times before making a significant turn higher in November when inflation came in below expectations and Fed Chairman Powell signaled a possible slowdown in rate increases. The US dollar fell hard, and gold broke out, rising to over US$1,800 in December.

Cost inflation (for miners)

Gold stocks went on a bigger roller coaster than gold in 2022. The NYSE Arca Gold Miners Index had a maximum drawdowns of 38.8% but ended the year with 2.4% losses. Cost increases combined with lower gold prices caused some companies to miss earnings. The industry guided increased costs in the five percent range early in the year. However, higher commodities prices brought on by the Russia-Ukraine war forced many companies to revise costs at a higher rate. It seemed that 2022 costs would have averaged around US$1,200 per ounce, up about 10% over 2021. While a few companies planned on trimming dividends, most dividends remained intact, and stock buybacks continued along with healthy margins. The recent positive gold price trend, along with early indications that costs should remain around current levels, would bode well for the miners in 2023.

Gold in 2023: Re-emergence amid a gloomy outlook?

Quite a few things that worked against gold in 2022 turned positive. Inflation peaked around mid-year and appears to be heading lower. Many retailers and manufacturers had bloated inventories, and ports, railroads, and package delivery trucks have spare capacity. These prompted the Fed to reduce the size of its rate hike in December, with further reductions or pauses probable in 2023. The US dollar bull market run may end since US Treasury rates were down from October peaks. The DXY declined 9.8% from its 20-year highs in September, and we expect to see the US dollar weaken further if a recession develops. Several reasons to expect economic weakness in 2023:

• Record yield curve inversion;
• A common belief is that the Fed policy is felt in the economy with a lag. In 2023, the economy will feel the force of one of history's most aggressive rate hiking cycles;
• A reeling housing market from high mortgage rates and unaffordable pricing. According to Redfin Corp, luxury home sales fell 38% year-on-year in the three months that ended in November, the most on record since 2012^*; and
• Consumers projected spending of the last of their pandemic-era stimulus savings in 2023.

Geopolitical tensions and deglobalisation have many non-western central banks diversifying away from the US dollar. Net central bank gold purchases in 2022 were one of the strongest years on record. There has been a growing reluctance to rely on the US dollar for forex reserves and commerce since Western sanctions have frozen over half of Russia’s US$500 billion in forex reserves. Many countries see no guarantees that the US won’t use the US dollar to retaliate for some future infraction that is less egregious than bombing a neighbour. As this new world order evolves, there could be less demand for the US treasuries that enable the US to maintain its deficit-fueled lifestyle.

The financial system has operated under ultra-easy and unprecedented monetary policies for over a decade, characterised by low-interest rates and massive quantitative easing. With its first rate increase in March, the Fed has just begun to attempt to normalise policies. Inflation remains far above its two percent target, and its balance sheet of treasuries and mortgage-backed securities is over US$8 trillion. Just nine months of tightening financial conditions has resulted in the cratering of the housing market, a crash in cryptocurrencies, a derivatives debacle for British pension funds, and the collapse of a major cryptocurrency exchange. What tail risks will the next nine months bring as a slowing economy is likely to be added to the mix?

Ballooning deficits and inflation waves: Make gold a solid choice?

Higher interest rates create extraordinary systemic risks as monetary conditions continue to normalise. The monthly federal deficit was a record US$249 billion in November. On December 30, President Biden signed a US$1.65 trillion omnibus spending bill. The government continues to pile on to its US$31.3 trillion national debt, which is equal to 124% of GDP, while debt service is becoming a major expense. Recently, the Wall Street Journal’s Greg Ip quoted a 1981 paper by Thomas Sargent and Neil Wallace: “A government that runs unsustainable deficits will, one day, fail to sell enough bonds, at which point the central bank will have to finance the shortfall by printing money. The central bank may initially try to control inflation by raising interest rates sharply. But this will widen deficits further and ultimately make inflation even harder to control.”^**

The US Consumer Price Index (CPI) has trended from a peak of 9.1% in June to 7.1% in November, indicating that the first inflation wave is ending. Will there be a second wave? In 1974, the CPI peaked at 12.3%, then fell to 4.9% in 1976. Many thought inflation was finished; however, it roared back to peak again at 14.7% in 1980. Today, the labour market remains tight, while trade and supply chains have become more difficult since the pandemic and the Russia-Ukraine war. The current inventory glut should prove temporary as we expect China’s economy to emerge from its COVID-19 quagmire eventually. Energy markets will see more volatility, while the rush to green technology will keep upward price pressure on many commodities. Once the Fed stops tightening, we will be watching for the next inflation wave. The Fed might find a second wave more difficult or even impossible to deal with.

A shift in gold’s investment outlook can be seen in bullion ETF flows. Global bullion ETFs experienced heavy outflows from April to November. The outflows have now stopped, and while a stronger catalyst is needed to prompt inflows, at least the selling pressure has abated. Perhaps 2023 will bring a renewed focus on the yellow metal.