New threat to higher gold prices: COVID-19's 'deflationary spiral' - Capital Economics
(Kitco News) Gold prices saw an impressive recovery on Tuesday, nearing $1,700 an ounce on increased demand and a stock market recovery. But one research firm is warning of significant downside risk to gold prices.
“The possibility of a deflationary cycle poses a major downside risk to our forecast,” said Capital Economics commodities economist Alexander Kozul-Wright. “Worries that the current crisis may result in a period of deflation pose a bigger threat to the gold market.”
After getting caught up in a massive equity selloff earlier in March, gold prices are now seeing a bounce up amid surging demand for the precious metals driven by the COVID-19 panic.
“Fire sales of gold have seemingly given way to safe-haven buying following … unprecedented intervention by the Federal Reserve. Providing the Fed has injected sufficient liquidity to defend against a further collapse in equity prices, we expect the gold price to tread water,” Kozul-Wright noted.
Now that the initial selloff in gold to cover for losses elsewhere is over, a new threat is forming on the horizon — a potential period of deflation.
“The 2-year inflation compensation in U.S. bond markets recently pitched into negative territory, a sign that investors are concerned about deflation. That said, longer-dated inflation compensation remains positive, suggesting that investors remain sanguine about an extended deflationary cycle,” Kozul-Wright pointed out.
The risk is not fully formed yet, according to Capital Economics, but could lead to lower demand for gold in the future.
“Demand for gold may taper off if investors display growing concern about a deflationary spiral,” the commodities economist noted. “Given that nominal interest rates have almost reached their effective lower bound, further falls in expected inflation should raise the yields (and lower the prices) of real assets, such as gold. In contrast, other safe havens with fixed nominal coupon payments, like U.S. Treasuries, may become more attractive.”
Capital Economics’ year-end outlook for gold is $1,600 an ounce, with prices trading largely sideways throughout the year.
“Near-term safe-haven buying [will] eventually give way to a gradual turnaround in global growth. Our end-2020 gold price forecast is $1,600 per ounce. However, if fears about a deflationary spiral gain traction, the gold price could fall,” Kozul-Wright said.