Gold does what it’s supposed to do

The yellow metal has served as an insurance for Australian investors during this correction.

Summary: Over the past three weeks, the Australian stock market has fallen around 12 per cent, but the gold price has risen 6.1 per cent in Australian dollar terms. Since I bought a one ounce bar of gold at the Perth Mint in early January, I am almost exactly square – which is better than losing money! The outlook for gold today remains largely unchanged despite concern that a US rate rise could put downward pressure on the gold price and upward pressure on the US dollar.

Key take-out: Gold is an insurance policy against changing market conditions which, in Australia’s case, seem to be a slide for the local dollar and perhaps a higher US dollar gold price.

Key beneficiaries: General investors. Category: Gold.

Amid the market turmoil of the past week it is interesting to note that the asset class which outperformed all others is also the oldest, the one famously tagged as a “barbarous relic” by Lord Keynes... gold.

It’s not that the gold price did much. It was a case of most other assets falling and gold either clawing back a little lost ground in US dollar terms, or doing somewhat better in Australian dollar terms thanks to further weakening in the Australian currency.

The outlook for the foreseeable future after last night’s see-saw price moves on the New York Stock Exchange is for much the same, with gold performing its act as a counter-balance to what happens in conventional financial markets, or as an insurance policy against bad government decisions.

Whatever the explanation for gold’s role in the investment world it is hard to ignore, barbarous relic or not.

A few numbers tell the story about another phase in the era of uncertainty which has followed the 2008 global financial crisis – including the critical question of when will the US raise its official interest rates?

Over the past three weeks, from July 31 to last night, the Australian stock market, as measured by the All Ordinaries index, has fallen by close to 12 per cent – and the less said about that the better.

During those same three weeks the US dollar gold price has crept up by $US42 an ounce, or 3.8 per cent from $US1098/oz to $US1140/oz.

In Australian dollar terms the gold-price increase over the past three weeks has been 6.1 per cent, rising from $A1505/oz to $A1597/oz thanks to the exchange rate drifting down from US72.94c to US71.34c.

That currency effect is something I’ve been banging on about for the past year because gold is one of the easiest ways for an Australian investor to buy “insurance” against a falling Australian dollar by acquiring an asset universally traded in US dollars.

To test my theory that the Australian dollar will continue falling in line with the country’s deteriorating terms of trade, as it has done in the past, I bought a one ounce bar of gold at the Perth Mint in early January when the gold price was $US1256/oz and the exchange rate was US82.19c (see Golden moment: It’s time to top up, January 21).

The gold price has fallen since then, but the Australian dollar has fallen further, meaning I am modestly in front. The one-ounce bar cost $A1575/oz (including Mint charges) versus last night’s gold price of $A1597/oz. After charges, should I sell the gold back to the Mint I am almost exactly square today – which is better than losing money!

The outlook for gold today remains largely unchanged despite concern that when the US starts raising interest rates (this year or next) the move could apply downward pressure on the gold price, and upward pressure on the US dollar.

But as so often happens in financial markets, what you expect and what you get can be very different, including the possibility that the eventual increase in US interest rates might not damage gold as much as feared – largely because the damage has already been done.

Since the “taper tantrum” of 2013, when markets gyrated wildly after a warning that the US central bank would start slowing (or tapering) the amount of money it pumped into the economy, investors have been on high alert for an end to the era of super-low interest rates.

Less loose cash, the threat of higher interest rates, and a strengthening domestic economy have combined with weakness in China’s growth rate to drive the US dollar higher and commodity prices lower.

Whatever does happen with US interest rates it is interesting to look back at previous periods of rising rates to see that an opposite reaction to what is expected can occur.

One recent analysis of three previous periods of rising rates revealed that the market moves ahead of the start of an upward rate cycle, rising by an average of 9 per cent in the six months before the first move up and, more interestingly, down by 6 per cent in the six months after the first increase.

There is no guarantee that history will be repeated though financial markets often adjust early, especially to well-telegraphed moves such as an eventual return to more conventional interest rate settings.

David Kelly, chief global strategist at the US bank, JP Morgan, told the Bloomberg news services last week that “the assumption that the dollar has to go up as the Fed tightens is not borne out by history”.

For Australian investors the prospect of a fall in the value of the US dollar after the first interest rate rise might also imply a fall in the Australian gold price – though that assumes that Australia’s terms of trade stabilise, which seems unlikely given China’s economic wobbles.

For gold, a fall in the US dollar could be an interesting development given that it has been falling for almost four years against the US currency.

However, the gold-price equation is complex thanks to its many moving parts and trying to guess what happens next is a fool’s game.

It is far better to see gold for what it is, an insurance policy against changing market conditions which, in Australia’s case, seem to be a long slide lower for the local dollar and perhaps a higher US dollar gold price.

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