Overall trend – Gold dropped 0.8 percent in the third quarter after rising 7.4 percent in the second and 16 percent in the first. It peaked at $1,375, its highest since March 2014, early in July before consolidating amid speculative profit-taking and weakness in the jewellery sector. We think that gold will experience some nervousness in the fourth quarter due to growing investor fears over a possible Fed rate increase in December but we believe the metal will ultimately pass the test. We feel the uptrend that began late in 2015 is set to continue over 2017.
Frenzied rally paused in Q3 – The rally triggered by the UK’s unexpected decision to leave the EU on June 24 proved unsustainable. Because macroeconomic and financial conditions remained resilient – contrary to investor expectations – gold’s appeal as a protection against tail risk diminished, which resulted in a slower investment and speculative demand for gold – – representing about 25 percent of total demand – than in previous quarters. As well, elevated price levels continued to exert downward pressure on jewellery demand, accounting for 56 percent of total demand. The weak state of physical demand in China and India, the largest consumers at 31 percent and 28 percent of total jewellery demand respectively, was evident in the downtrend in physical premiums, partly owing to the strong price elasticity of demand.
Uptrend likely to be tested in Q4 – Although jewellery demand could pick up a little, in part thanks to positive seasonality in Asia, we believe that gold prices may be vulnerable to episodic selling pressure in the fourth quarter, reflecting weak or even negative investment and speculative demand. Prices have already dropped below $1,240 in early October. While the macro backdrop for gold was somewhat friendly in the third quarter – the dollar and US real rates edged down slightly – in part thanks to a patient Fed, it could become increasingly unfriendly in the fourth quarter. Our macro analysis suggests that the Fed will progressively prepare the market for a rate increase at its December meeting and therefore guide investors toward a steeper expected path of Fed funds rate, which should lift the dollar and US real rates. Investors and speculators may in turn overreact to the resurgence of Fed hawkishness and reduce their long exposure to gold. At the same time, lower prices are likely to elicit some physical buying, especially in India amid the forthcoming festival and wedding season, which should provide some
Finally, while the political risks are particularly elevated in the fourth quarter, especially in Europe and the US, we do not think that they revive safe-haven demand.
But gold should survive – Although gold is likely to face strong headwinds in the fourth quarter, we expect the uptrend starting at the end of last year to remain intact in the fourth quarter and the whole of 2017 for a confluence of factors. First, although the Fed may lift rates once this year, we think it will remain “behind the curve” for a long period of time because of its asymmetric capability to respond to macro shocks – US monetary policy remains close to the zero lower bound. The expected path of the Fed funds rate should therefore continue to flatten over the coming quarters and produce a friendly macro environment for gold. Second, gold is likely to remain an attractive investment in a world of negative interest rates – a third of global government bonds are trading at a negative yield, prompting investors to re-allocate funds from negative-yielding assets to non-yielding gold. Finally, central bank demand, accounting for 14 percent of total gold demand, is set to remain solid because reserve managers tend to view gold as an increasingly important asset in their diversification strategies. The pace of monetary demand for gold should therefore remain sufficiently robust in the coming quarters to offset the lacklustre demand in the jewellery sector and push gold prices higher for longer, we feel.