Why the gold rally may signal further dollar weakness

Contrary to the postelection consensus outlook for a stronger dollar for this year, the greenback has slumped since January-and a clue to the potential for continued weakness can be gleaned from gold prices, according to Simon Derrick, chief market strategist at BNY Mellon.

In a note to clients on Wednesday, Derrick said that the recent rally by gold GCQ7, -0.39% which is threatening to break out of its post-2011 downtrend, suggest the decline in the dollar since January may be a longer-term trend that many expect.

On Wednesday, gold futures were off by 0.4% at $1,291.40 but remain up 10.5% year to date. Meanwhile, the ICE U.S. Dollar index DXY, +0.07% was up 0.2% at 96.837, though down 5.3% since the beginning of the year.

Investors typically buy gold to hedge against rising inflation, with the prices of the yellow metal offering its biggest returns in periods when headline inflation runs above of Federal Reserve target rates.

For example, gold rallied between 1971 and 1980 as inflation rose, then slumped over the following two decades as inflation fell.

More recently, gold hit an all-time high in September 2011 at $1,876.90 a troy ounce, then spent the following four years in a downtrend.

By the time gold hit a multiyear low in December 2015, headline inflation had already moved back above the Fed funds target rate, and the yellow metal shined for the next nine months, until investors were gripped by uncertainty ahead of the U.S. presidential election in the fall of 2016.

"Another, rather more interesting relationship began to emerge at the start of 2016. Much as in the early 1990s, gold began to track directly to moves in the U.S. yield curve (with yield curve flattening helping fuel gold strength/USD weakness and vice versa)," Derrick wrote.

The first chart shows the relationship between gold prices and the yield curve (10-year TMUBMUSD10Y, +0.28% minus 2-year TMUBMUSD02Y, -0.30% Treasury yields, inverted), with Derrick noting that the 50 basis point tightening of the spread was matched by a 14% rally in the gold price:

The following chart shows the relationship between the yield curve and the U.S. dollar.

Derrick explains that the U.S. dollar, which over the past five years provided the most attractive yield among major currencies, has been losing its edge as long-term Treasury yields slumped in response to softer economic data and expectations of slower path of rate increases in 2018.

"It would appear to be exactly this downward pressure on the USD that gold is reacting to. Given how rarely trends in gold prices have shifted over the decades, this latest move may therefore be the first real sign that the USD decline that began to emerge at the start of this year is developing into something rather more medium-term in nature," Derrick wrote.