Why Gold ETFs Are Plunging

The lowest level since Brexit―that's where gold prices stand after a $44 sell-off on Tuesday sent the yellow metal plunging below $1,300 for the first time in more than three months. The 3.4% drop in prices pushed gold's year-to-date gain down to 19.5%―still impressive, but down from the 29% gain at this year's peak.

Gold-tracking ETFs such as the SPDR Gold Trust (GLD) and the VanEck Vectors Gold Miners ETF (GDX) were hammered as well on Tuesday, with the latter dropping nearly 9% (GLD is now up 19.2% year-to-date, while GDX is up 70.6%, down from a sizzling 128% in August).

YTD Returns For GLD, GDX

 

What happened this week to make gold and gold ETFs fall so hard?

Rising Rate Hike Expectations & Dollar

News headlines attributed this week's declines to rising Fed rate hike expectations and a rally in the U.S. dollar.

According to futures markets, the probability of a rate hike in December is now greater than 60%. Those probabilities got a lift following better-than-expected data on U.S. manufacturing and hawkish comments from a pair of Fed officials earlier in the week.

Meanwhile, the U.S. dollar hit a 31-year high against the British pound on Tuesday, while the broader U.S. Dollar Index hit a two-month high.

All of these factors were considered gold-negative, and were enough to push gold down to $1,270, effectively erasing all of the post-Brexit gains the yellow metal had seen.

Gold Demand Cools

Though these financial factors are clearly worth considering in any analysis of gold's price action, it's easy to forget that there are many other drivers of the yellow metal.

Moreover, those other fundamental drivers are proving extremely weak so far in 2016.

For example, gold jewelry demand during the first half of the year fell nearly 50% to the lowest level since 2009, according to the World Gold Council. At the same time, purchases by central banks were down 23% year-over-year in the period.

For much of the year, dismal demand in these segments of the gold market was overshadowed by the sizzling rise in investment demand. Indeed, WGC figures show that investment demand during the first half of the year accounted for nearly half of global gold demand, the first time that has ever happened.

Most of that investment demand came from individuals and institutions buying gold ETFs such as the aforementioned GLD and the iShares Gold Trust (IAU), which took in a combined $14.3 billion during the first six months of the year.

But that strong first-half showing hasn't carried on into the second half of the year. Early indications are that much less new money came into gold ETFs during the third quarter. Without fresh buying by investors, gold's weak physical fundamentals are exposed and make it easier for prices to head lower.

Investors Still Like Gold

Still, it's important not to paint too dire a picture for gold. The increase in gold prices during the first half of the year was stellar, and prices are still up strongly on the year even after this week's pullback (that's even more the case for gold miner ETFs).  

Lower prices may prompt consumers and central banks to step into the market and make purchases they have been holding off.

Also, critically, investors remain enamored with gold. Though they haven't added to their positions in the last few months, neither have they headed for the exits.

That could change if the Fed gets more aggressive with rate hikes or the dollar suddenly surges. For now, all of the factors that drove investors to buy unprecedented amounts of gold in the first half of the year―low-to-negative interest rates being the most important―are still in place.

That suggests gold prices aren't set to collapse any time soon, and may be poised for a rebound once the current sell-off runs its course.

Contact Sumit Roy at [email protected].