What's expected in gold after the recent rally

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The recent Israel-Hamas conflict sparked a gold rally, primarily driven by short-covering. The question now is whether this rally will be sustainable.

Before the Israel-Hamas War, the COT (Commitment of Traders) Report indicated that large speculators were taking short positions in the gold futures market. However, following the conflict, within just two weeks these short positions were largely covered, and there was a modest increase in long positions. Assessing how much risk premium has been factored into the price of gold is challenging. Given the ongoing situation's uncertainty, short-term speculators are likely to remain cautious and refrain from shorting gold until the situation becomes clearer.

Large speculator net holdings from COT report of Commodity Futures Trading Commission (CFTC)

Gold as a safe-haven commodity

Gold is often considered a safe haven asset; however, according to the ABN Amro report released on 10 March 2022, the reliability of gold's safe haven status is inconsistent. There are times when it behaves as a secure investment and other times it exhibits characteristics of a risk asset.

Reflecting on historical events such as the 9/11 terror attack in 2001, the Crimea war in 2014, and the Russia-Ukraine conflict in 2022, gold market experienced notable surges of 6.5%, 11%, and 11%, respectively. Presently, the Israel-Hamas conflict has reached an advanced stage, with Israel yet to deploy ground troops. Additionally, should other nations become embroiled in this conflict, gold market has already seen a 7.5% increase in value. In the event of further escalation, the likelihood of gold experiencing additional surges remains a distinct possibility.

The question arises: Have demand-side dynamics played a prominent role in shaping the direction of the gold market?

The supply of gold remains relatively stable, with a consistent quarterly range of around 1,100 to 1,250 tonnes. What predominantly influences the price of gold is the demand side, particularly the investment demand.

Gold ETFs play a crucial role in maintaining the balance of supply and demand for gold. When there is an outflow of funds from ETFs, it often triggers a decline in the price of gold.

Looking at the chart above, it becomes evident that gold demonstrates stronger performance during periods of ETF inflows. Although we've heard reports of gold purchases by entities like the Chinese Central Bank, the Turkish Central Bank, and individuals in China this year, as of September 29, a net outflow from the ETF still exists. The demand in Asia has not been sufficient to offset the outflows from the rest of the world. And gold didn’t perform very well.

What factors influence the demand for gold, particularly in terms of investment? Is its appeal as a safe haven, as a protection against inflation, or the impact of monetary policies driving the demand for gold?

• Safe haven
  As mentioned previously, the ABN Amro reports indicate that the safe haven characteristics of gold are inconsistent.

• Inflationary hedge

Based on the chart above, during the low inflation period from 2000 to 2006, gold exhibited a weak correlation with the US CPI, showing a correlation coefficient of -0.055. Similarly, from 2007 to 2023, gold did not demonstrate a strong correlation with inflation, with a correlation coefficient of 0.36.

For instance, when we compare the peak gold price of 2020, which was 2,075 USD, and the inflation rate of 2% in 2023, the peak gold price remains at 2,075 USD while inflation has risen to over 7%. If gold were an effective hedge against inflation, we expect its value to have surpassed the 2020 peak.

• Monetary policy
  

The chart above illustrates the connection between gold and the US three-month yield, revealing a historical pattern where gold rallies when yields decline, notably since 2006.

The question now arises: Are we approaching a turning point? Will the Fed persist with rate hikes? If market sentiment begins to factor in the possibility of a rate cut by the Fed, it could signal the beginning of a gold rally.

According to the model from the Atlanta Fed, the three-month yield is anticipated to begin decreasing, with the earliest projection in January 2024 and no later than June 2024.

While the comparison between gold and JPY as well as gold and GBP has reached all-time highs, it doesn't necessarily guarantee that gold will establish a new record high against the USD. However, it does suggest that gold is likely to continue strengthening when measured against other currencies.

On certain occasions, both the USD and gold have risen simultaneously, as illustrated in the lower chart depicting XAU/USD vs. USD/EUR. The shaded area represents periods when both USD and gold experienced concurrent rallies.

Technical Analysis

Chart pattern: On the long-term gold chart, a cup and handle pattern is taking shape, with the left side of the cup forming in 2011. Gold appears to be currently in the process of forming the handle. If gold manages to breach the resistance level at 2,080, we can anticipate a further rally. It's important to note that support is expected to arrive around 1,800.