Gold has had a bad month, but bullish activity could suggest a bottom
The price of gold has dropped 5 per cent since the end of May. The majority of this decline can be attributed to an increase in interest rates following a recent US Federal Reserve Open Market Committee (FOMC) meeting).
As inflation concerns grew, the Fed signalled a more “hawkish” direction with an expected hike in the policy rate by 2023, earlier than the market had thought. In turn, US two-year rates almost doubled from 14bps by the end of May to an intra-day high of 28bps on 18 June.
Gold’s reaction is not surprising given it has experienced higher sensitivity to interest rates over the past year. Investor positioning prior to the most recent Fed meeting also indicated that gold was likely overbought and could pause its ascent or even retreat in the short run.
Now that a pullback has materialised, the gold options market shows some interesting dynamics forming. Historically, from a volatility perspective, when gold sells off quickly, we usually see the “put skew” increase as investors are willing to pay a premium to protect against further downside.
After the most recent selloff, however, we have seen the put skew decrease or “cheapen”, suggesting investors may be selling out-of-the-money (OTM) put options to gain long exposure to gold at a price they might consider more attractive.
By the same token, while implied volatility has risen, it has so far only done so slightly, moving up about one volatility point to a level of 16 (equivalent to a 16 per cent annualised expected volatility). This is still on par with historical average levels.
By means of comparison, during previous similarly sharp downward moves, we have often seen gold’s implied volatility reach levels closer to the 20’s. This could suggest that some of the selloff is being buffered by buyers, who may see this as a tactical opportunity but also by investors building strategic positions.
While investors may still be concerned about further downside risk, their positioning suggests that many of them believe the selloff could be overdone and they could be using this higher implied volatility to gain long exposure to gold at a more attractive level.
While gold fell by 7 per cent in June, we have seen positive gold-backed ETF inflows, even as the gold price fell sharply after the Fed meeting. In particular, North American funds, whose flows often move in the same direction of price and often with larger magnitudes, have actually seen inflows this month. This is a further indication that investors may be taking advantage of the lower price level to gain long gold exposure.
While we had previously seen the overbought technical indicators prevalent in the gold price, the opposite has now happened. Gold remains in a longer-term bullish trend as long as it holds above the US$1,750 support level.
Ultimately, the long-term strategic rationale for a gold allocation remains. Inflation expectations remain higher, which has historically been good for gold with average nominal returns exceeding 15 per cent during times when US CPI was above 3 per cent. And while higher rates may be a short-term headwind, the absolute levels of those rates are still extremely low. Longer dated rates such as 10- and 30-year US Treasuries have held steady, indicating that investors have adjusted their short-term expectations, but not their expectations for the longer-term.
Gold has very much tracked money supply globally over recent years. This is likely to continue with many countries committed to additional monetary and fiscal stimulus.
Gold continues to play a strategic role in portfolios. Understandably may overweight or underweight strategic positions based on market developments. And, with gold market positioning suggesting downward pressures may still remain, some investors are also using the recent pullback as an opportunity to strengthen their core position.