Is this the top investment idea for 2023?

An expected decline in US interest rates and a weaker US dollar make this asset class attractive, according to one analyst. Our City writer explains.

Gold has been backed as one of a City bank’s top investment ideas for 2023 as the precious metal’s price gets a boost from an expected pivot on US interest rates.

UBS’ base case is for gold to end next year at $1,900 an ounce, but with a potential upside to $2,250 as the Federal Reserve cuts rates from around 5% to 3.25% by the end of 2023.

Gold is sensitive to the monetary policy outlook as higher interest rates dent the appeal of holding non-yielding bullion, although this relationship has been tested in recent years.

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Despite significant tightening by the Federal Reserve over the past year, the gold price has retained a position above $1,600 and stands above $1,750 an ounce in trading today.

Gold’s usual hedge against high inflation and geopolitical uncertainty has been one factor for this resilient performance, although this month’s analysis by UBS shows just how far the link to higher rates has been broken.

In the past, every 100-basis point increase in US 10-year real yields would have typically resulted in gold falling in the range of 14% to 20%. Yet this year, gold has only fallen by 6% despite a 277-basis point rise in yields.

UBS thinks strategic diversification has prevented gold from selling off even further, a result of a much broader investor base than a decade or so ago.

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These investors are holding relatively small allocations to gold rather than a few having large exposures, implying better endurance to the rise in rates and strong dollar seen this year.

This is highlighted by the more measured pace of selling in gold ETFs (exchange-traded funds) this year compared to the period following the Fed's 2013 'taper tantrum'.

Strong physical demand has also provided support as key markets in India and China have bought large volumes of gold this year, encouraged by cheaper prices. In addition, retail investment demand for gold coins and bars in Western markets has been robust, likely driven by the appeal of holding real assets in a high-inflation environment.

UBS thinks that the prospect of a decline in US real rates and a weaker US dollar against G10 currencies means the risk-reward of building a long position in gold is now attractive.

It warned that the timing of such a move is tricky as in the near-term real rates could still push higher and as the Fed is expected to hike rates in the first quarter of 2023.

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UBS added: “That said, we think any weakness should ultimately offer better entry levels and position for a move higher in prices over the course of 2023, as the Fed ends tightening and eventually shifts to a dovish stance.”

The bank admits there are several risks to its base case, including an upside scenario where a more severe global housing downturn forces the price towards $2,000 an ounce.

UBS explained: “Prices are likely to rally as Fed cuts extend to 2024, taking policy rates lower than our base case, and real rates move back into negative territory. Gold should also benefit from stronger safe haven flows, with weaker equity markets highlighting gold’s role as an alternative asset.”

A period of persistent price pressure is regarded as the most bearish scenario, despite the well-known narrative of gold being an inflation hedge.

This is because it would result in a more hawkish Fed policy, higher real rates, and a stronger dollar. In this environment, UBS sees prices testing below $1,600 before stabilising and recovering back above $1,800 towards the end of the two-year period to 2024.