Gold’s unusual behaviour is due to a desiccation in the physical market

Gold is a traditional safe haven asset, a place where investors find refuge when risk assets are shaky and financial markets are under a heavy selling pressure, or under a threat of sell-off.

There is long historical evidence that gold maintained its value during times of market turbulence for two major reasons.

First, gold is universally recognized as an asset of value, and our modern financial system is based on gold. In their early days, banks backed money by gold reserves. This is no longer true in our days, but the trust in gold as a value of storage remains strong.

Second, gold cannot be printed infinitely as money. It is a rare metal with a limited supply. Hence its value cannot be impacted by a durable oversupply. Therefore, gold has proved to be a powerful hedge against inflation.

From a statistical perspective, the negative correlation between gold and risk assets provides a powerful diversification tool to investors, especially during times of heavy market unwinds. Gold thus serves as an effective hedge in times of distressed markets.

Gold rallied from $1200 to $1700 per oz from the mid-2018 to the beginning of 2020 on the back of a heated trade war between the US and China. Investors gradually piled up their gold holdings on mounting threat that the trade disruption between the US and China would lead to a slower global growth, lower company earnings and decline in equity valuations.

Although the equity markets rallied to the all-time high levels during this period, the anxiety regarding the US-China trade war was the major driver of sentiment in the markets until the beginning of 2020, when the signature of a phase-one trade deal between the two countries gave a very short sigh of relief to investors.

This seems a faraway memory now, as the coronavirus outbreak hit the headlines just after the deal and grew in importance since then.

As such, gold's final stretch to the $1700 mark was fueled by a historical decline in equity and credit markets. But gold couldn’t provide the protection needed during the entire market meltdown and ran out of steam halfway as the bloodbath across equities continued at full speed.

We observed that gold’s negative correlation to risk assets broke too frequently, leaving investors unhedged against colossal declines across equity and corporate bond markets.

This unusual behaviour in gold prices was partly due to a disturbed activity in the physical gold market worldwide. In fact, gold mines and refineries halted their activity due to coronavirus-led shutdowns, causing scarcity in the global physical gold market. This situation led to liquidity issues in non-physical gold markets, an unusually high price volatility and disrupted price behaviour vis-à-vis the other asset classes.

As such, trading gold became significantly costlier, and holding gold became riskier, encouraging investors to liquidate their gold positions and seek ‘safer’ safe havens. As a result, we have seen accrued inflows into the US dollar.

Goldminer stock prices, which recorded sustainable gains from mid-2018 took a severe dive along with other sectors, meanwhile gold held on to its gains at multi-year highs despite a clouded behaviour. Despite being 1.10% up since inception in 2017, Swissquote’s Gold & Metal Miners retraced to the levels last seen in Q4, 2018.

Quid next? Will gold and miners fall from grace due to the recent desiccation in physical gold markets?

Certainly not. The short-term disruption in gold’s ability to hedge against a market rout should have a limited consequence in the medium to long run.

This is especially true as we are stepping into an era of massive monetary and fiscal stimulus that will flood the market with extra cash. Although the post-2007/2018 financial crisis proved that the extra liquidity didn’t cause a significant rise in inflation, the ultra-expansive policies deployed across developed economies should have a significant positive impact on consumer prices, if however we see a plausible upside correction in energy prices. Hence, gold should continue offering an efficient protection to investors against the risk of overheated inflation.

But in the short run, the direction is cloudy.

From a technical perspective, gold should remain in the long-term bullish trend above the $1500 mark, which is the major 38.2% Fibonacci retracement on mid-2018 to 2020 rally. Yet, the precious metal should meet solid offers near and above the $1700 an ounce and the upside potential should be severely compromised nearing the $1800 mark.

A slide below the $1500 level will send gold in the neutral consolidation zone between $1500 and $1350.

Breaking the major 61.8% Fibonacci support at $1350 should indicate a deeper downside correction in the long-term trend and encourage a further decline toward the $1200 level.