The risk of a policy error by the world’s central banks means that investors should be considering exposure to safe-haven assets such as gold, according to investment analysts. 
For much of the past decade, market sentiment has been dominated by the actions of central banks after the likes of the Federal Reserve, Bank of England, European Central Bank and Bank of Japan launched bold monetary stimulus programmes in response to the global financial crisis.
However, most central banks are now reducing this stimulus, or talking about reducing it, by lifting interest rates and closing off the quantitative easing programmes that have pumped trillions of dollars of liquidity into financial markets.
Federal Reserve’s effective federal funds rate since 2000
Source: Board of Governors of the Federal Reserve System, fred.stlouisfed.org
Ned Naylor-Leyland, manager of the Old Mutual Gold & Silver fund, said: “As the US and eurozone central banks begin unwinding their unconventional monetary policies – involving purchasing unprecedented amounts of bonds to inject liquidity into financial markets – the risk of a policy error triggering a sell-off grows
“Investors are increasingly asking if gold can act as a hedge against the impact on markets of central bank policy misfires while diversifying portfolios into the bargain.”
The Federal Reserve has increased rates twice in 2018 so far, taking the target federal funds rate range to between 1.75 and 2 per cent. The latest rise took place in June and was the seventh since 2015.
Gold has not had the strongest start to 2018, despite the year witnessing a number of early sell-offs and heightened investor nervousness on the back of a potential trade war between the US and China.
FE Analytics shows the S&P GSCI Gold Spot index fell 4.59 per cent in 2018’s first half, which was largely put down to the strength of the US dollar acting as a headwind for the yellow metal.
Analysts at Bank of America Merrill Lynch said a stronger dollar, rising inflation and healthy US growth held back the metal in the opening half of 2018. “Going forward, we see some upside to gold, but expect price gains to materialise only if USD weakens, global/US growth starts to slow and cross asset volatility remains elevated,” they added.
Naylor-Leyland noted that gold prices tend to rise when real rates are falling and decline when real rates climb. This means the outlook for US monetary policy and inflation are key to the fortunes of gold: expectations for rate rises climbing more slowly than those for inflation is positive while the reverse is negative.
Performance of gold in H1 2018 in dollars
Source: FE Analytics
Since December 2015 – which was the first time the Federal Reserve lifted rates since before the financial crisis – the gold price has traded in a relatively narrow range.
Naylor-Leyland suggested that this reflects “the faith the markets have in central bankers’ actions”. However, he continued: “We doubt this state of play will last for long. If trust in policymakers recedes, the gold price will rise sharply in a rush to buy ‘safe-haven’ assets.”
The manager noted that the post-crisis bull run has been one of the longest expansionary periods on record thanks to the ultra-loose monetary policy employed by central bankers.
But he said this should come as “little surprise”, given the fact that these “artificial” conditions created by these policies have forced up the prices of risk assets and put a lid on volatility.
“The implication is that, at the very least, central bank attempts to return to something approaching the historical norm threatens those elevated prices and low levels of volatility,” Naylor-Leyland continued.
To support this argument, the manager has reviewed the performance of gold during six periods of sharp falls in the MSCI World index: the bursting of dotcom bubble in the early 2000s, the early days of the financial crisis in the summer of 2007, the ‘main’ 16 months of the financial crisis, the oil price collapse in 2014, the Chinese growth scare of 2015 to 2016, and the surprise jump in volatility in early 2018.
Gold did not make positive returns in all of these periods, falling in 2018’s volatility, the oil collapse and the prelude to the global financials. However, the metal did outperform global equities in each of the six periods.
Performance of gold vs equities during financial crisis in dollars
Source: FE Analytics
As the chart above shows, the period of gold was particularly strong during the global financial crisis. While Naylor-Leyland did not say he was expecting falls of this magnitude as monetary policy tightens, he argued that gold could be a useful portfolio holding as markets shift into a new environment.
“We believe that even the most successful withdrawal of central bank support for markets will see more volatile, and divergence between, risk asset prices,” he concluded.
“As such, it makes sense to consider if it is time to diversify a portfolio with an allocation to gold.”