While U.S. Treasury yields hit new highs at the end of last week's trading session, driving the U.S. dollar higher against major world currencies, the price of gold continued to advance on demand out of both China and India. Scuttlebutt surrounding the Federal Reserve's expected scaling back of its current course of quantitative easing drove Treasury prices lower. The combination of this Fed action and a strengthening dollar has usually led to weakness in precious metals. The question investors now must ask is whether the increased demand will be sufficient to overcome the influence of an apparently stabilizing economy.
The Treasury market The yield on the 10-year Treasury note reached as high as 2.866% on Friday, a level not seen since July 2011. The expected action from the Fed is largely believed to have pushed yields higher – and prices, therefore, lower. A Reuters poll released last week showed that the majority of economists expect the central bank to scale back its bond buying at its mid-September meeting; the prevailing estimate is that the first tapering action will reduce the $85 billion per month by $15 billion per month. The reduction in buying demand should reduce prices and thus allow rates to uptick marginally, as we saw on Friday.
The U.S. dollar reacted as expected to the move, strengthening against major world currencies. The enhanced yield makes the dollar more attractive, driving the currency's strength against alternatives. This has usually been bearish for gold, which serves as a safe haven, particularly when dollar-denominated assets are weak.
World demand The weakness expected in the gold market never materialized, based largely on reports that demand for gold from both India and China continues to rise. Reuters reported that the World Gold Council believes India's consumer gold demand could surpass 1,000 tonnes this year, putting India and China in competition to be the largest gold consumer in 2013. In both countries, this demand is being driven by the want of physical gold for consumer uses like jewelry.
In addition to this demand, there are other signs that strong demand is helping to stabilize and drive prices. Last Friday, the SPDR Gold Trust (ETF) (NYSEARCA:GLD) – the world's largest gold ETF – increased its supply of stored physical gold by 1.8 metric tons. Still, the World Gold Council has warned that demand has not been sufficient to keep pace with the decline in investor interest – hence the significant fall in gold prices.
The path ahead The question is whether demand pressure will be sufficient to drive gold prices higher, or whether the effect of Fed action and other global macroeconomic events will ultimately win out. With China heading into its wedding season, and India demonstrating growing demand in the face of several increases in import taxes to curb buying, the appetite on the world stage appears sustainable. On the U.S. front, while a slowdown in Fed stimulus may have a short-term negative impact on gold prices, the follow-on downward pressure this could put on equity markets should neutralize, or reverse, this pressure. I do not foresee runaway gold prices returning in the immediate term, but the yellow metal looks worthy of some allocation from here.