Gold prices break out to 8-year highs on rising demand

Central banks have been the catalyst for the rise in the price of gold


Gold prices have been rising and have broken through 8-year highs as rising demand is driving up the price of the yellow metal. Central banks have been the catalyst for the rise in the price of gold, and looking forward hedge funds could help push prices to multi-decade highs. From March through mid-June of 2020, gold prices have moved in tandem with riskier assets such as stocks, but it appears that the correlation has broken down. The recent drop in the US dollar has also created tailwinds for gold prices.

Gold Demand is Rising

Gold demand has been rising year over year, as some central banks are stocking up their reserves using gold instead of the US dollar. Most of the gold demand around the globe comes from jewelry.

Next, it is mostly used as an investment asset. Central bank's demand is approximately 15% of total demand but it appears to be growing. Central banks led by Russia and China have increased their stake in gold reserves purchasing approximately 374 tons of gold in 2019. As the US has increased trade tensions around the globe, adding tariffs to influence countries like China, the demand for US dollars has declined. This has been replaced with purchases of gold which continue to rise. Additionally, the risk and uncertainty of the US economy in the wake of the COVID pandemic have created a stronger demand for an alternative to the US dollar which has paved the way for higher gold demand.

What is also clear is that hedge funds are in the process of buying more gold as an investment. According to the most recent commitment of trader’s report released for the date ending June 23, 2020, hedge funds added 31,863 gold contracts to their long positions in gold. Each cold contract on the Chicago Mercantile Exchange holds 100 ounces of gold. This increase is equivalent to 3.18 million ounces of gold. The total open interest for hedge funds that are long gold futures and options contracts has increased to 205,519 contracts compared to 29,855 contracts that are should gold futures and options. This is offset by gold producers who are using the rising price to hedge future gold prices.

Hedge Fund Open Interest Can Rise

While the hedge fund open interest might seem large, and the increase is supportive, hedge funds have historically held more gold, as recently as February of 2020. As you can see in the chart of gold prices relative to the commitment of traders numbers, large speculators (hedge funds) were long 353,869 contracts of futures and options as of February 17, 2020. This could mean that hedge funds could increase their long position in futures and options pushing up the price of gold substantially as they purchase another 72% of the open interest to get back to the levels that were seen in February of 2020.

The Dollar Has Generated Tailwinds

In addition to the addition of hedge funds into the fray, gold trading has continued to experience tailwinds due to a decline in the US dollar. In March, April, May, and June the Federal Reserve announced a monetary policy that has helped reduce US interest rates. It initially started with the Fed cutting rates by 150-basis points which were followed by a reduction on rates to zero. The decline in US rates relative to many of its counterparts (such as Europe, Japan, and the UK) reduced the interest rate differential in short term interest rates. This makes up the forward curve and puts downward pressure on the US dollar.

Additionally, as the coronavirus has spread throughout the United States generating a new wave of the pandemic, traders have exited their long positions in the dollar which has helped buoy gold prices. Gold is quoted globally in US dollars. When the dollar rises, it makes gold more expensive in other currencies which needs to be offset by a decline in gold prices. When the dollar declines in value the opposite occurs helping to buoy gold prices.

The Bottom Line

The upshot is that gold prices are rising due to several factors including a falling dollar, and rising demand from both hedge funds and central banks. The decline in the dollar as a reserve currency around the globe has led many central banks to purchase gold bullion. The outlook for gold prices is positive. Not only have they broken out to fresh 8-year highs, but hedge funds are now just adding to positions that could take the yellow metal higher. Prices are likely to test resistance near the October 2012 highs near 1,796. A break of this level would lead to a test of the 2011 highs at 1,921.

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