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Why Gold Gains Strength Post-US Rate Cut: Asset Observation
Core Perspective
As of October 4, 2024, the London gold price has risen by 3.3% since the Federal Reserve's interest rate cut on September 18, and has accumulated a 28.6% increase this year. The strengthening of gold prices is not entirely attributed to the Federal Reserve's interest rate cut. Although the Federal Reserve's interest rate cut usually favors the rise in gold prices, considering that the gold price has already strengthened significantly before this round of interest rate cuts, the strong performance after the cut still exceeded expectations. In the month before this round of interest rate cuts, the 10-year U.S. Treasury futures price and the U.S. dollar index rose by 1.5% and fell by 1.4%, respectively, which basically matched the 2.5% increase in the London spot gold price. However, in the 13 trading days after the interest rate cut, the 10-year U.S. Treasury price weakened (the 10-year U.S. Treasury interest rate rebounded by 33 basis points, and the real interest rate rebounded by 22 basis points), and the U.S. dollar index rose by 1.5%, which is difficult to explain the 3.7% increase in the gold price. In addition, although the short-term U.S. Treasury interest rate once fell, its boost to the gold price was also relatively limited.
Gold benefits from the decline in the attractiveness of U.S. Treasury bonds. Since 2022, the traditional negative correlation between gold prices and the 10-year U.S. Treasury real interest rate has continued to weaken, showing a "gold strong, debt weak" pattern. Traditional analysis frameworks based on the U.S. dollar system, such as the World Gold Council's Gold Price Return Five-Factor Model (GRAM), find it difficult to explain the degradation of the correlation between gold prices and U.S. Treasury bonds. Since 2022, the "overshooting" of gold prices has reflected market concerns about U.S. fiscal and dollar credit. Since 2024, the U.S. government's debt has continued to expand, and the interest payment pressure has risen rapidly. The upcoming presidential election does not change the prospect of fiscal expansion. Recently, concerns about U.S. fiscal issues have intensified: First, the U.S. government once again faces the risk of a shutdown, and fiscal risks have prompted Moody's warning; second, geopolitical tensions in the Middle East and other regions continue to escalate, and the conflict between Lebanon and Israel has intensified, leading to expectations of increased U.S. military spending. Current speculative positions show that gold is more favored by investors than U.S. Treasury bonds. Due to the U.S. Treasury market being much larger than the gold market (in the past five years, the ratio of the increase in gold demand to the increase in U.S. Treasury supply and overseas demand is only 0.5% and 3.1%, respectively), the outflow of funds from the U.S. Treasury market (or the reduction of inflow funds) may have a significant pulling effect on the gold market.
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There may be short-term adjustment risks for gold prices. Under the backdrop of the Federal Reserve's interest rate cuts, gold is more attractive than U.S. Treasury bonds in this round, which is expected to make gold perform more strongly. However, gold prices may face certain short-term adjustment risks. First, the bullish gold positions have been crowded, and the "fear of heights" may affect the sustainability of the gold price increase. The proportion of non-commercial long positions in COMEX gold has been maintained above 60% since June. In the past 20 years, the proportion has not been above 60% for long, and the longest did not exceed 4 months. Second, the recent rebound in U.S. Treasury interest rates has gradually accumulated pressure on gold prices. Although the correlation between gold prices and U.S. Treasury (real) interest rates is not as strong as before, it has not disappeared. Finally, with the improvement of China's economic prospects, the demand for gold allocation by Asian funds may cool down. Since March of this year, as the 10-year Chinese bond interest rate broke through the 2.3% threshold, the gold price once accelerated its rise. This is due to the significant increase in the demand for gold allocation in China and the Asian region. With China's stable growth policy significantly taking effect, Asian funds that were actively allocating gold before are expected to flow back to China, which may trigger an adjustment in gold prices.
Risk Warning: The pace of the Federal Reserve's interest rate cuts is uncertain, U.S. Treasury interest rates or the U.S. dollar index may rise beyond expectations, and global geopolitical risks may rise beyond expectations, etc.
As of October 4, 2024, the London gold price has risen by 3.3% since the Federal Reserve's interest rate cut on September 18, and has accumulated a 28.6% increase this year. At the same time, the 10-year U.S. Treasury interest rate and the U.S. dollar index have not fallen, and the strengthening of gold prices cannot be entirely attributed to the Federal Reserve's interest rate cut. We believe that the continuous strengthening of gold prices reflects market concerns about U.S. fiscal and dollar credit, which in turn makes gold more attractive than U.S. Treasury bonds. Recently, the U.S. government once again faced a shutdown, and the escalation of geopolitical tensions in the Middle East further intensified market concerns about U.S. fiscal and debt issues. Looking ahead, gold is expected to perform more strongly in this round of the U.S. interest rate cut cycle, but considering the current crowded speculative positions, the recent rebound in U.S. Treasury interest rates, and the potential cooling of Asian allocation demand with the improvement of China's economic prospects, gold prices may face certain short-term adjustment risks.
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The strengthening of gold prices is not entirely attributed to interest rate cuts
The Federal Reserve's interest rate cuts usually favor the rise in gold prices, but considering that the gold price has already strengthened significantly before this round of interest rate cuts, the strong performance after the cuts still exceeded expectations. The experience of the past seven rounds of interest rate cuts is that gold prices are more likely to rise before the Federal Reserve's first interest rate cut, as market expectations for rate cuts come first, but after the start of the cuts, there is more likely to be fluctuating consolidation (refer to the report "Federal Reserve's Historical Interest Rate Cuts: Economy and Assets"). In comparison, starting from two months before the first interest rate cut, the London gold spot price has accumulated a more than 10% increase, and the amplitude and continuity of this round of gold price increases are strong, second only to 2019.Following this round of interest rate cuts, while gold prices have strengthened, the 10-year U.S. Treasury yield and the U.S. Dollar Index have not shown a significant decline. Prior to this round of rate cuts, the rise in gold prices was more closely related to the approaching rate cuts, as expectations of rate cuts led to a stronger U.S. Treasury market and a weaker U.S. dollar. In the month leading up to this round of rate cuts, the 10-year U.S. Treasury futures price and the U.S. Dollar Index rose by 1.5% and fell by 1.4%, respectively, which roughly matched the 2.5% increase in the spot price of London gold. However, as of October 1st, that is, in the 10 trading days following the rate cut, the price of the 10-year U.S. Treasury actually weakened (the 10-year U.S. Treasury yield rebounded by 33 basis points, and the real yield rebounded by 22 basis points), and the U.S. Dollar Index slightly increased by 1.5%, which is difficult to explain the 3.3% increase in gold prices.
Short-term U.S. Treasury yields have fallen in the week following the Fed's rate cut, but their boost to gold prices should be relatively limited. The peculiarity of this round of rate cuts is that the Fed rarely started with a 50 basis point cut, but guided the market to maintain expectations for a "soft landing" of the U.S. economy. According to CME FedWatch, after this round of rate cuts, the market's expected interest rate path once moved lower, that is, it was expected that the Fed would accelerate the pace of rate cuts, but the expected interest rate level a year later remained around 2.5-3%. This caused short-term U.S. Treasury yields to fall relatively quickly, such as the 2-year U.S. Treasury yield falling by 10 basis points between September 18th and 24th, during which gold prices also rose quickly. However, the historical correlation between gold prices and 2-year U.S. Treasury yields is not as strong as with 10-year U.S. Treasury (real) yields. Over the past two decades, the correlation coefficient between gold prices and 2-year U.S. Treasury yields is -0.20, while the correlation between gold prices and 10-year U.S. Treasury nominal and real yields is -0.54 and -0.60, respectively. From this perspective, the decline in short-term interest rates should have a relatively limited boost to gold prices. Not to mention, the market's expectations for short-term interest rates have recently been revised upwards, with the 2-year U.S. Treasury yield rebounding by 44 basis points between September 25th and October 4th, and a cumulative increase of 34 basis points since September 18th.
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Gold Benefits from the Decline in U.S. Treasury Attractiveness
Since 2022, the traditional negative correlation between gold prices and the 10-year U.S. Treasury real yield has continued to weaken, overall presenting a "gold strong, bonds weak" pattern. From 2003 to 2021, the correlation coefficient between gold prices and the 10-year U.S. Treasury real yield was -0.91, but from 2022 to September 2024, the correlation coefficient between the two became 0.44, and the traditional negative correlation temporarily diminished. Specifically, the outbreak of the Russia-Ukraine conflict in March 2022 marked the beginning of the divergence between this round of gold prices and U.S. Treasury real yields; after March 2024, gold prices further "immunized" against the rebound of U.S. Treasury real yields and rose against the trend, intensifying the degree of divergence.
The traditional analytical framework based on the U.S. dollar system finds it difficult to explain the degradation of the correlation between gold prices and U.S. Treasuries. The World Gold Council's Gold Price Return Five-Factor Model (GRAM) divides the factors driving gold prices into five major factors: economy, risk, exchange rate, interest rate, and market momentum. In most historical periods, the above factors can better explain the changes in gold prices. The model shows that the rise in gold prices in February-March 2022 was mainly contributed by the "risk factor"; the high returns on gold prices in March-April 2024 are difficult to explain with the five factors, with a high model residual, indicating that the traditional analytical framework based on the U.S. dollar system is temporarily ineffective.
We believe that since 2022, the "overshooting" of gold prices reflects the market's concerns about U.S. fiscal and U.S. dollar credit. After the outbreak of the Russia-Ukraine conflict in 2022, the United States implemented various economic and financial sanctions, triggering international questioning of the status of the U.S. dollar. In the first half of 2023, against the backdrop of a decline in the international reserves of the U.S. dollar, the outbreak of a U.S. banking crisis, and the approaching U.S. debt ceiling crisis, discussions on "de-dollarization" once heated up, and gold prices rose significantly (refer to the report "How to View the 'De-Dollarization' Trend?").
Since 2024, the U.S. government debt has continued to expand, the pressure of interest payments has risen rapidly, and the election does not change the prospect of fiscal expansion. The total U.S. debt reached a historical peak of $35.35 trillion on September 17th of this year, a year-on-year increase of 7%, and a 56% increase compared to the same period in 2019. As of the second quarter of this year, the total interest expenditure of the U.S. government (annualized) rose to $1.09 trillion, a year-on-year increase of 22%, and an 86% increase compared to the same period in 2019; the total interest expenditure accounted for 3.1% of the current debt total and 3.8% of the current GDP (annualized). Currently, both parties in the United States hold an expansionary fiscal stance, Trump's election will maintain the 2017 tax cut law, and Harris's election may also increase family tax relief and other fiscal support, increasing the size of the U.S. fiscal deficit in the coming years (refer to the report "Harris: Campaign Advantage, Policy Outline, and Trading Clues").
After this round of rate cuts, concerns about U.S. fiscal issues continue to intensify:
Firstly, the U.S. government is facing the risk of another shutdown, and fiscal risks have prompted Moody's warning. The U.S. government's fiscal year for 2024 will end on September 30th, and Biden's previously proposed spending plan for the fiscal year 2025 has been shelved, putting the U.S. government at risk of another shutdown. According to the Committee for a Responsible Federal Budget (CRFB), since 1976, the U.S. government has累计 experienced 20 "funding shortages" and led to 4 government shutdowns. The Republican-controlled House of Representatives rejected a bill on September 18th that supported government funding continuation until March 28, 2025, and finally passed a more temporary bill on September 25th, only supporting funding until December 20th to temporarily avoid a government shutdown. On September 24th, Moody's warned that political polarization could make it more difficult for the new U.S. government to address the deteriorating fiscal situation and threaten the U.S. sovereign credit rating.Secondly, geopolitical tensions in the Middle East and elsewhere continue to escalate, with the conflict between Lebanon and Israel intensifying and expectations of increased U.S. military spending. Since September 23, Israel has launched large-scale airstrikes on Lebanon; on September 27, the United Nations warned that the tensions between Israel and Hezbollah in Lebanon could escalate into one of the deadliest conflicts in the region in recent years. Harris has inherited Biden's stance on Middle Eastern issues, pledging to support Israel. On September 26, the Israeli Ministry of Defense announced that Israel had received $8.7 billion in military aid from the United States. The escalation of the situation in the Middle East not only increases the demand for safe-haven assets in the international market, thereby raising gold prices, but also raises market concerns about the uncontrolled growth of U.S. military spending and dollar debt.
Current speculative positions indicate that gold is more favored by investors than U.S. Treasury bonds. Gold and U.S. Treasury bonds have historically been considered "safe-haven assets," typically becoming attractive for investment after interest rate cuts or the outbreak of global risk events. During the Federal Reserve's interest rate cut cycle in 2019 and the impact of the COVID-19 pandemic in 2020, non-commercial long positions in COMEX gold and CBOT 10-year U.S. Treasury bonds were at historically high levels. However, before and after the Russia-Ukraine conflict in 2022 and the recent Federal Reserve rate cut, due to the weakening of the U.S. dollar's credit, gold long positions remained high, but U.S. Treasury bond long positions were significantly low.
Due to the U.S. Treasury bond market being much larger than the gold market, the outflow of funds from the U.S. Treasury bond market (or the reduction of inflow) could have a significant pulling effect on the gold market. According to data from the World Gold Council, we have calculated that in the past five years (2019Q2-2024Q2), gold demand denominated in U.S. dollars increased by an average of $2.5 billion per quarter, while the average quarterly increase in the outstanding balance of U.S. Treasury bonds was $529.4 billion, and the average quarterly increase in foreign investors' holdings of U.S. Treasury bonds was $81.2 billion. The ratio of the increase in gold demand to the increase in U.S. Treasury bond supply and overseas demand was only 0.5% and 3.1%, respectively. In the second quarter of 2024, global gold demand increased by a significant 75.1 tons (or $17.4 billion), far exceeding the average level of the past five years, and the proportion of gold demand to U.S. Treasury bond supply and overseas U.S. Treasury bond demand increased to 17.5% and 18.2%, respectively.
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Gold prices may face short-term adjustment risks
Against the backdrop of the Federal Reserve's interest rate cut, gold is currently more attractive than U.S. Treasury bonds, which could lead to stronger performance for gold. However, considering the current crowded speculative positions, the recent rebound in U.S. Treasury bond yields, and the potential cooling of Asian allocation demand due to the improvement in China's economic outlook, gold prices may face certain short-term adjustment risks.
Firstly, the crowded long positions in gold may affect the sustainability of gold price increases due to a "fear of heights" sentiment. Since 2004, the proportion of non-commercial long positions in COMEX gold has shown a mean-reverting trend, with a volatility center at 48.5%. As of the week ending October 1 this year, the proportion of non-commercial long positions was 69.4%, setting a new historical high, and has been basically above 60% since June. In the past two decades, the proportion of non-commercial long positions above 60% has not been very long, and the longest did not exceed four months. In 2017, 2020, and 2021, when long positions decreased from high levels, they all triggered a phased sideways movement or a slight adjustment in gold prices.
Secondly, the recent rebound in U.S. Treasury bond yields has gradually accumulated pressure on gold prices. Historically, under a "soft landing" scenario for the U.S. economy, the 10-year U.S. Treasury bond yield often experiences a phased rebound 1-2 months after the first interest rate cut. In our report "The Expected and Unexpected of a 50BP Interest Rate Cut," we pointed out that after the Federal Reserve started the interest rate cut in this round, there may be certain upward risks for the U.S. economy and inflation. As of October 1, the Atlanta Fed's GDPNow model forecasted a 2.5% annualized growth rate for U.S. GDP in the third quarter. Recently, due to the Federal Reserve's expectations guidance and the latest stronger-than-expected non-farm employment data, the 10-year U.S. Treasury bond yield has rebounded significantly, and the pressure on gold prices has also been gradually accumulating. Although the correlation between gold prices and U.S. Treasury bond (real) yields is not as strong as before, it has not disappeared. From April this year to September 18 before the Federal Reserve's interest rate cut, the rise in gold prices was more or less synchronized with the decline in 10-year U.S. Treasury bond real yields.
Lastly, with the improvement in China's economic outlook, Asian capital's allocation demand for gold may cool down. The correlation between gold prices and Chinese bond yields has increased in the past year. Particularly observed since March this year, as the 10-year Chinese bond yield broke below the 2.3% threshold, gold prices accelerated their rise. This is due to a significant increase in the allocation demand for gold in China and the Asian region. According to data from the World Gold Council, China's "investment" demand for gold (including bars, coins, and ETFs, etc.) increased significantly from 49.3 tons in the second quarter of 2023 to 80 tons in the second quarter of 2024, with a year-on-year increase of 62%, while the global "investment" demand only increased by 1% year-on-year. In addition, in the second quarter of this year, physical gold ETFs in the Asian region grew significantly year-on-year, performing the best globally. Since September 24, China's stable growth policies have significantly increased, and with the improvement in economic prospects, Asian capital that was actively allocated to gold is expected to flow back to China, which may trigger an adjustment in gold prices.Risk Warning: The pace of interest rate cuts by the Federal Reserve is uncertain, U.S. Treasury yields or the U.S. Dollar Index may rise beyond expectations, and global geopolitical risks may escalate beyond expectations.
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