Frankincense and myrrh may no longer be traditional Christmas gifts, but the appeal of gold endures. For investors, however, the yellow metal lost a little of its luster in 2018.

In late December, the gold price was down 4.5 percent ($1,255 per ounce). It had also suffered the indignity of being surpassed by palladium as the most valuable precious metal, something that last happened in 2002 when gold languished at levels around $450/oz.

Gold and Real Yields

Gold faced three main headwinds in 2018: rising (real) interest rates; a strong U.S. dollar; and, until recently, relatively low levels of equity market volatility. There are sound reasons to believe that these factors are evolving into tailwinds.

Real yields are the difference between cash yields on bonds and the (forward) inflation rate. Real yields have been rising for most of the year and in October the U.S. 10-year real yield rose above 1 percent (10-year Treasury 3.2 percent, 10-year inflation break-evens 2.17 percent). This may not sound very exciting, but it was the first time since early 2011 real yields breached 1 percent.

This matters for gold because unlike other assets it does not have a yield and is often bought as an inflation hedge. If investors can be paid 1 percent above inflation for holding a risk-free asset, gold seems like an unnecessary luxury. The assets held by the world's biggest gold-backed exchange-traded fund (ETF) (GLD - Get Report) fell in 2018 by $2.7 billion to $31 billion.

However, real yields have reversed of late. Inflation expectations have barely budged but the yield on the 10-year Treasury has fallen to 2.77 percent. Though the Federal Reserve raised rates by 25 basis points, as expected, at its December meeting, real rates may have peaked as the Fed cycle nears its end. The opportunity cost of holding gold has fallen.

Tracking With Volatility

One positive for gold prices from rising U.S. interest rates of late has been the rise in equity market volatility. 2017 saw the VIX index completely becalmed and gold followed a similar path. During the entire course of the year there was not a single day in which the gold price moved higher or lower by 2.5 percent or more, the lowest recorded volatility since 2006 (U.S. equity markets volatility was the lowest since 1964).

In just one week between Oct. 3 and Oct. 10, 2018 the VIX spiked from 11.61 to 24.98. It remains at these levels, more than 10 points higher than at any time in 2017. As Figure 1 shows, gold followed the VIX higher, reasserting its status as a diversifying safe-haven. Gold also rallied as stock markets fell in the immediate aftermath of the Fed's December rate rise.

The final headwind, a strong U.S. dollar, may have also blown itself out. The DXY index rose from 89 in February to a peak of 97.5 in November and has edged lower since. With the European Central Bank beginning the process of policy normalization by ending QE, interest-rate differentials look set to converge.

Gold reassumes safe haven role. Source: Bloomberg, World Gold Council

Gold's Catalyst

Any bull market needs a catalyst; for gold it is likely to be portfolio flows. When attempting to price any asset, particularly a commodity, most economists would look at supply and demand dynamics. Gold production is price inelastic and the approximately 190,000 tonnes of gold worldwide available in the form of jewelry, bullion and coins (60 years of current gold mining output) can be brought to market at low cost.

Investors are the marginal buyers of gold and the biggest influence on price. In the third quarter, central banks bought the largest amount of gold to add to their reserves since 2015, according to the World Gold Council. Russia's net purchases hit their highest on record (92.2 tonnes) and the Polish central bank bought gold for the first time since 1998.

Reserve managers are likely to be a continuing source of demand in 2019. Whereas the likes of the United States, Germany, France and Italy hold more than 60 percent of their reserves in gold, China and India hold 2.3 and 5.8 percent, respectively.

A significant short position in gold futures in October is now a modest long, according to the December 14 Commitments of Traders (COT) report. There is still plenty of scope to add to this. Similarly, GLD, the biggest gold-backed ETF, reported $120 million of inflows in the latest month, but that still leaves $2.5 billion of buying to get back to its previous 2018 assets under management peak.

Investment flows will determine whether a lackluster 2018 turns into a happy New Year for gold.

Written by Andrew Capon. Read more from the author here.

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