Gold Market Commentary: When the dollar turns on itself

Dip buyers emerge

Gold gained another 5% in February to reach US$5,222/oz; it is now up 20% y-t-d. Performance in other currencies, however, was mixed: a sharp Indian rupee appreciation following tariff relief with the US, saw local prices drop 3.5%; likewise, a surge in the renminbi saw local prices fall.

Our Gold Return Attribution Model (GRAM) suggests that contributions to the positive return came from a weaker US dollar, particularly against EM currencies (Chart 1). A lower 10-year US Treasury yield also helped. But the model missed the positive return with a large positive residual. A sharp drop in implied volatility following the surge in January could have dragged gold down further in the first half of the month, but it was likely held up by strong Asian buying – evidenced both by gold returns during Asian trading hours and high volumes on the Shanghai Futures exchange. This is not explicitly captured in our model.

Gold ETFs added US$5.3bn to assets in February (+26t), led by North America and Asia, with Europe seeing outflows of US$1.8bn (-13t). Managed money net long positions on COMEX contracted sharply in early February, before picking up a little steam towards the end of the month.

When the dollar turns on itself

The downward trend in the US dollar index (DXY) is likely to resume post this near-term bounce and is, in our view, a key positive force for gold prices going forward.

The DXY avoided a technical downside breakdown in January, helped by positive economic surprises and supportive futures positioning (Chart 2). But we view this as a temporary respite. The case for medium-term dollar weakness rests on these factors:

• Relative to history and to other countries, the US dollar and US equities remain expensive
• The "double reward" for foreign investors (strong US equities + strong dollar) is fading, with Europe and Japan in particular offering genuine alternatives
• Previous dollar bear markets have also seen relative equity market weakness, and the initial currency falls have been steep, possibly due to the reinforcing loop of investor outflows
• A weak dollar is more consistent with the current US administration’s policy of encouraging reshoring
• Weaponisation of the US dollar after the onset of the Ukraine invasion has made central banks and other investors more cautious about US exposure.

The US remains expensive

Both on a Real Effective Exchange Rate (REER) basis and price to sales – a number that is a little harder to adjust than earnings – the US remains expensive (Chart 3).

The “double reward” may be fading

Foreign investors have been facing a choice: hedge US exposure (and accept lower returns) or rotate elsewhere (Chart 4). There are tentative signs that this is happening and the rationale is quite strong: fiscal headroom in Germany, better valuations, reform momentum in Japan, and political and concentration risks in the US.

Previous dollar bear markets were long and front-loaded

Should these outflows continue, they could amplify the trajectory of a weaker currency and poorer prospective returns. Previous major US dollar bear markets experienced large initial drops, possibly a function of this vicious circle (Chart 5), which coincided with equity underperformance. 

So far, however, this marginal rotation is focused more on equities than bonds, with US Treasuries still attracting inflows. With interest rate differentials arguing that the dollar is fairly valued, equity flows may become more important in dictating where the dollar goes from here.

What it means for gold

Dollar weakness, high policy and geopolitical uncertainty, and more volatile capital flows are conditions that favour gold. And continued central bank diversification into gold provides further support.

But there are risks for gold too:

• High prices will likely be of continued concern to some investors
• Should financial flows help drive stronger growth in Europe, Japan and elsewhere, gold in those countries may become relatively less attractive in an environment of strong domestic equity markets and growth. We have already seen some European gold ETF outflows in February as the January price surge prompted profit taking.

Conflict arises

The Middle East conflict that erupted at the end of February saw an immediate and unsurprising reaction from asset prices on Monday 2 March. Oil prices climbed, the dollar rallied, and yields softened somewhat. Gold also bounced, up almost 5% across two trading sessions. Historically it has responded positively in about two-thirds of instances in which geopolitical tension has spiked significantly. But the next two weeks are less certain, with gold showing a broader range of returns (+8% to -3%) and a hit rate that falls to 57%.

Bottom line: the dollar bounce - boosted by the current conflict - is likely short-lived, and a resumption in the downtrend should be supportive for gold.