Can gold keep its shine?

Gold has been among the best performers this year.

The precious metal has outshone equity markets and high yield bonds with a gain of nearly 15%, to trade at USD 1,215 an ounce.

But can gold retain its appeal during a period of rising US federal funds rates? It gave up some of its gains in May after the Fed indicated that monetary tightening is likely in the coming months – a scenario many in the markets had come to consider improbable.

Most of gold’s rally is probably over for now. We believe the Fed will hike rates twice in 2016 – an outcome to which markets still assign only a 41% probability. This faster pace of tightening should put gold under pressure over the coming months, since higher rates raise the opportunity cost of holding the metal. As a result, it is possible that gold could slip below USD 1,200 over the next three months.

Still, we think the downside for gold is limited over a 12-month horizon, and there are three main reasons gold should be trading close to current levels in a year’s time.

1) Falling real rates

While nominal US interest rates are heading higher, we believe that real interest rates – nominal rates minus inflation – are likely to fall in the months ahead. The recent rise in the oil price and tight labor markets make it probable that the inflation rate will climb. Meanwhile, the Fed remains in go-slow mode and is unlikely to accelerate rate hikes even if inflation climbs modestly above its official target of 2%. A negative real interest rate erodes the purchasing power of cash, making real assets, like gold, more attractive.

2) Rising production costs

The price of mining gold fell in recent years due to lower energy costs and the sliding value of the currencies of many emerging nations, where the bulk of gold is extracted. Now this process is reversing. The recovery in the oil price and emerging market currencies is making mining more expensive again, which should support the global price somewhat.

3) Long-term growth in China and India

Economic growth rates in the two countries are an important determinant of the gold price. Both have a cultural affinity for gold, and jewelry demand rises as middle class incomes expand. Last year China and India accounted for almost half of global demand for the metal. US citizens, by contrast, were responsible for just 4% of purchases. While China is slowing, it still looks set for GDP growth of 6.6% this year, compared to 1.5% for the US. India is likely to be the world’s fastest growing large economy both this year and next.

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