Gold prices and the U.S. dollar continue to be dueling forces in the market, with one of the big narratives centering around tumbling gold prices as the U.S. dollar continued to strengthen. The dollar reversed course last week after the latest Consumer Price Index reading, but then this week marked yet another reversal, as the dollar began strengthening again while gold prices plunged. Analysts seem to expect the dollar to continue strengthening while gold prices fall as the market zeros in on the negative correlation between these two assets, highlighting its importance over other factors impacting gold prices.
Inverse correlation with U.S. dollar now of greater importance for gold
In a note dated May 10, Helima Croft, head of Commodity Strategy for RBC Capital Markets, and her team highlighted the increasingly important play between the U.S. dollar and gold prices. They said that at this point, the dollar is now driving gold prices while rates and Treasuries take a backseat. They noted that since the middle of last month, gold prices have been weakening while the dollar has strengthened, but then after the last CPI reading, the dollar fell along with Treasury yields, while equities climbed.
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Further, they explained that although each of these exert differing influences on gold prices, the importance of each one has been shifting since the beginning of this year. The RBC team noted that the negative correlation with the U.S. dollar has grown this year, along with its importance as an influence over gold price. In fact, while the inverse correlation between the dollar and gold has increased this year, the negative correlation between gold and 10-year Treasuries/ rates has declined. Additionally, gold’s correlations with inflation expectations and equities have been fluctuating “inconsistently” since the beginning of the year.
Croft and team said that this implies that rates are taking a back seat in terms of influence of gold. Still, even though interest rates now seem to be of lesser importance than the dollar when it comes to gold prices, it doesn’t mean that rates aren’t having any impact at all. She explained that the market will also be watching “the potential path of rate hikes and any possible deviation from consensus,” even while focusing mostly on the dollar against gold.
When gold prices tango with the U.S. dollar
The correlation between gold and the U.S. dollar has been an interesting one to watch this year, which is probably one reason the market is so focused on it right now. For a brief time earlier this month, gold prices moved in step with the U.S. dollar rather than inversely, as both appreciated in the first three days of the month and then fell the next day before breaking this unusual correlation a few days later.
Macquarie analysts Viktor Shvets and Perry Yeung said in their recent note on the U.S. dollar that they see a strong possibility that the dollar will become “much stronger” than it has been. They also said that “theoretically,” the “anomaly” of the U.S. dollar and gold appreciating together could end up becoming a “consistent trend.”
At this point, it doesn’t look like that’s happening, as these two assets broke their positive correlation last week a couple days after the Macquarie team wrote their report, based on charts from Macro Trends. The negative correlation between gold and the dollar has returned and gotten stronger, as the RBC team pointed out.
Why a stronger dollar seems likely
The Macquarie team noted several signals which could demonstrate that the dollar will strengthen further from here. They noted that the U.S. Dollar Index began appreciating just as the consensus settled on a long-term bearish trend for the currency. The index breached 92 and now has shifted up into the 93 range, and now Macquarie analysts warn that the big danger for the next 12 months is that the dollar could appreciate dramatically.
They feel that investors are already noticing that supply of the dollar has weakened and now is about half the rate it was at six months ago. They noted that the contraction in the monetary base is driving this weakening as the Fed slashes its balance sheet. Meanwhile, the U.S. seems to be unable to “significantly widen” its current account deficit in spite of high levels of federal spending. Further, they noted that real spreads have gotten high on a historical basis, while some of the negative positioning on the dollar is being unwound. They warned that the situation could get out of control, adding that it’s the “intensity” rather than just the direction of the move that’s important.
The Macquarie team also noted that the U.S. dollar is being driven by the overall view of it as “the global store of value and medium of exchange.” They explained that only the U.S. dollar satisfies all the conditions required for a reserve currency. As a result, there are always bids for the dollar, and they added that the only things that could weaken this is strong reflation or further quantitative easing.
Additional QE seems very unlikely, as more and more data points show strengthening in the U.S. economy, which is causing the consensus to hike its expectations for interest rate increases.
Gold poised to fall further
Since the market seems to be favoring the dollar as the major indicator of gold prices, it stands to reason that gold is expected to keep tumbling, based on all the signs pointing to further strengthening of the dollar.
On Wednesday, gold prices hit a new low for 2018, plunging even further under $1,300 an ounce while the dollar recorded its second consecutive day of gains, global equities fell, and longer-term interest rates soared to their highest level in seven years. It was the sixth losing day for gold in the last seven trading sessions, driven by strong retail sales numbers for April, marking the second consecutive month of retail sales growth.
Kitco Metals analyst Jim Wyckoff told MarketWatch that when gold plunged below $1,300, it also breached an important technical support level. That triggered “a large number of pre-placed sell stop orders in the futures market,” which poured even more fuel on gold’s fire sale. However, not everyone is predicting a steady plunge for gold prices. Gold Newsletter editor Brien Lundin told MarketWatch that gold is holding its own in non-dollar currencies, so he expects overseas bargain hunters to support the price, preventing a plunge to the $1,250 neighborhood.