What's Next as Gold Prices Reach New Highs and the Correlation with Real Interest Rates Weakens?

Over the past two months, gold prices have surged, rising by almost 13% since October. This outperformance of other major asset classes has caught the attention of many investors. During this trend, it is noteworthy that gold prices have once again broken away from their traditional negative correlation with real interest rates.

After three years of consolidation, gold prices have once again surged and hit $2,100 per ounce. However, this recent spike in gold prices differs significantly from previous ones, deviating once again from the traditional negative correlation between gold and real interest rates.

In October, gold prices remained strong despite the increasing pressure of real interest rates reaching new highs. In early November, as real interest rates began to decline, gold prices also started to correct. The traditional negative correlation only gradually re-emerged since mid-to-late November.

In general, gold tends to have a negative correlation with real interest rates due to the opportunity cost of holding gold. However, in recent years this relationship has been broken many times, as indicated by the 1-year rolling correlation coefficient between gold and the inflation-adjusted 10-year Treasury yield charted below. The coefficient has been positive in 2012, 2018, 2022, and 2023. A more complex geopolitical and economic environment may be a contributing factor to this outcome.

Various factors like safe-haven demand due to geopolitical conflicts, central bank gold purchases, de-dollarization, inflation expectations, Federal Reserve interest rate hikes, etc., impact the price of gold in different directions. The intensity of each factor also varies from time to time, leading to differences between the price of gold and actual interest rates. This weakening or even breaking away from negative correlation is evident in recent times.

Gold prices have surged due to several factors. In addition to market expectations of interest rate cuts by the Federal Reserve and the significant decline in U.S. Treasury yields, this recent surge has also been driven by an increase in safe-haven demand amid ongoing disturbances from the Middle East conflict. Moreover, ultra-strong buying by global central banks has provided additional support to gold prices.

2. The new round of conflicts in the Middle East that broke out on October 7 intensified geopolitical risks. After a brief seven-day ceasefire agreement, conflicts renewed on December 1, leading to increased uncertainty in geopolitical conflicts that continued to disturb gold prices.

3. Global central banks' gold purchases hit a record high. According to data from the World Gold Council, global central banks purchased 337 tons of gold in the third quarter of 2023, which was the third-highest quarterly net gold purchase in history. The continuing frenzy of central bank gold buying provides support for gold prices.

Analysts hold differing views on whether gold can maintain its strength in the next stage and what new supporting factors may emerge.

Some analysts have suggested that the slowdown in U.S. personal consumption expenditure growth in October and the lower-than-expected U.S. ISM manufacturing index in November may indicate an upcoming economic downturn in the United States. These factors, along with mounting expectations of imminent Fed rate cuts, are believed to be contributing to the favorable conditions for a bullish gold market.

The increasing geopolitical complexity and continued central bank demand for gold purchases under de-dollarization are also supporting gold prices. In addition, the return of global gold ETFs to net inflows has released positive signals. Data shows that the SPDR Gold ETF, the world's largest gold ETF, reversed its trend of continuous reduction in positions since May this year in late October.

Despite this, other more cautious analysts have also highlighted headwinds that could potentially limit gold's further rise. These include the possibility of profit-taking after reaching a record high, a potential rebound resulting from the rapid decline in US Treasury yields, and a marginal reduction in safe-haven demand due to the improvement in relations between major economies.