Three reasons why gold won't tank

Gold bars
Akos Stiller | Bloomberg | Getty Images

Talk of upcoming Fed rate hikes has caused gold to give up some of this year's gains. But we believe that the potential downside for gold is limited. Real U.S. interest rates – the key determinant of the gold price – are likely to fall further into negative territory. In 12 months we forecast gold to be near its current price of $1200 an ounce, retaining most of its bounce from below $1100 since the end of last year.

Gold has been among the best performers this year. The precious metal has outshone equity markets and high yield bonds with a gain of nearly 15 percent, to trade at $1215 an ounce. However, gold retreated in May after the Fed indicated that monetary tightening is likely in the coming months. Many in the markets had previously come to consider this scenario for Fed tightening to be improbable.

Most of gold's rally is probably over for now. We believe the Fed will hike rates twice in 2016, most likely in September and December – an outcome to which markets still assign only a roughly 40 percent probability. This faster pace of tightening should put gold under pressure over coming months, since higher rates raise the opportunity cost of holding the metal. As a result, it is possible that gold could slip below $1200 over the next three months.

Still, there are three main reasons gold should be trading close to current levels in a year's time.

  1. Falling real rates: While nominal U.S. interest rates are heading higher, we believe that real interest rates – nominal rates minus inflation – are likely to fall in the months ahead. The recent rise in the oil price and tight labor markets make it probable that the inflation rate will climb. Meanwhile, the Fed remains in go-slow mode and is unlikely to accelerate rate hikes even if inflation climbs modestly above its official target of 2 percent. A negative real interest rate erodes the purchasing power of cash, making real assets, like gold, more attractive.
  2. Rising production costs: The price of mining gold fell in recent years due to lower energy costs and the sliding value of the currencies of many emerging nations, where the bulk of gold is extracted. Now this process is reversing. The recovery in the price of oil and emerging market currencies is making mining more expensive again, which should support the global price somewhat.
  3. Long-term growth in China and India: Economic growth rates in the two countries are an important determinant of the price of gold. Both have a cultural affinity for gold, and jewelry demand rises as middle class incomes expand. Last year China and India accounted for almost half of global demand for the metal. U.S. citizens, by contrast, were responsible for just 4 percent of purchases. While China is slowing, it still looks set for GDP growth of 6.6 percent this year, compared to 1.5 percent for the U.S. India is likely to be the world's fastest growing large economy both this year and next.

Overall, we believe the downside for the gold price is limited over a 12-month horizon. We maintain our sideways forecast of $1150-1350 an ounce in three months and $1200 in 12 months.

Commentary by Mark Haefele, global chief investment officer at UBS Wealth Management, overseeing the investment strategy for $2 trillion in invested assets. Follow UBS on Twitter @UBSamericas.

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