Interest rates and inflation have no doubt been some of the hottest topics on the street for the past few years. These two variables have a significant effect on a country’s currency, and the matter of foreign exchange and currency exposure has been front of mind for many investors. An increasingly popular line of questions from gold investors has been whether one should start looking at currency hedging, especially in the context of what appears to be diverging interest rate paths between the Fed and the RBA. In this article, we answer important questions about currency hedging, address the historical implications of hedging gold and introduce the Global X Gold Bullion (Currency Hedged) ETF (ASX: GHLD).

Key Takeaways

Hedged gold may be appropriate for investors who want pure gold exposure without contending with fluctuating foreign exchange.
Hedging gold can provide ‘purer exposure’ to price performance – however it can come at the cost of gold’s crisis hedging and diversification benefits.
Hedged gold has consistently outperformed unhedged gold in the years following rate-cut cycles in the US.

What is Currency Hedging?

When investors purchase gold in Australia, they make a two-fold bet. First, and self-evidently, the investor speculates on the future price of gold. Secondly, investors make a bet that the US dollar (USD) will appreciate against the Australian dollar (AUD). This is because gold is most commonly traded and priced in US dollars, and as such, any unhedged gold exposure is also an investment in the USD. For investors who may simply wish to access gold without the hassle of foreign exchange, this dynamic represents a certain risk to their investment.

Consider, for example, an Australian investor who invests in unhedged gold, which then proceeds to double in value over a certain period of time. In the case that the AUD also doubles in value, the investor may find that their investment outcome in AUD terms actually nets out to zero growth at all, making what appeared to be a successful trade a meaningless endeavour. Of course, had the AUD depreciated by half instead, the investor may find their investment doubled in value – a boon to say the least.

Graph: Investment Value: Currency Fluctuations

These hypothetical scenarios are extreme examples, and such volatility is rarely observed in developed market currencies. But they nonetheless demonstrate the unpredictability of unhedged exposures and its potential to put the value of your investment at risk. A risk conscious investor can seek to remove this unpredictability by currency hedging their investment.

Why Currency Hedge Your Gold?

There are three main reasons that an investor would want to invest in gold: diversification, crisis hedging, and tactical trading. Of those three tasks, unhedged gold has historically been very good at two. For one, unhedged gold is uncorrelated with most traditional portfolio exposures, making it a great diversifier. Secondly, both gold and the USD tend to appreciate in times of geopolitical tension or unexpected market downturns. This is due to their reputations as safe haven assets, making unhedged gold also a very effective tool for crisis hedging.

However, this is not to say that currency hedged gold cannot be used as an effective diversifier. Over the past decade, hedged gold has had a lower correlation to global equities, broad commodities and Australian government bonds than unhedged gold. For investors with significant exposure to these assets, hedged gold may still be an appropriate long-term holding.

Table: Correlation Matrix: Hedged Gold Vs Unhedged Gold

But for most investors, hedged gold is most appropriate for tactical trading and capitalising on movements in the gold price. As a trading tool, hedged gold offers multiple advantages over unhedged gold. For example, over the past 20 years, the AUD/USD pair has had a moderate correlation of ~0.40 with the gold price in USD. This means that the AUD tends to move in the same direction as gold and as such, positive movements in gold price can often be eroded through foreign exchange fluctuations.¹

Graph: AUD/USD is Positively Correlated with Gold Price (USD)

Furthermore, over the same period, unhedged gold has risen by an average of 22.01% in rolling 12-month periods where the USD fell by at least 10%. This makes sense given gold’s historically negative relationship with US interest rates, but it once again means that Aussie investors would’ve seen many of gold’s strongest rallies cut short by a weakening USD. In these instances, hedging your gold would have provided the ‘purer’ exposure and allowed you to capture the full extent of gold’s performance.

Table: Gold Tends to Rally When USD Depreciates By 10% or More

Interest Rates and Currency Hedging

Many investors gravitate toward currency hedging when US interest rates are in flux. The USD’s position as the world’s reserve currency means that any fluctuations in its value can have significant implications for the global economy and in particular, precious metals prices. As such, we analysed gold’s performance both hedged and unhedged during and after the Fed’s rate cut cycles over the past 50 years to see how each exposure has performed.

Table: Hedged Gold Outperforms Post Fed Rate-Cut Cycles

At first glance, hedged gold appears to perform roughly in line with unhedged gold during the rate-cut cycles in the US. However, one might notice that hedged gold has also consistently (with the exception of 1989-92) outperformed unhedged gold in the years following the last rate cut – likely due to AUD outperformance.

We believe this is due to the nature of the AUD as a ‘risk asset’ tied to the performance of global commodity demand. Historically, Fed rate cuts have correlated with economic downturns and the end of rate cut regimes usually mark the beginning of a global recovery – something which benefits Australia as an economy reliant on the export of metals and other goods. A healthy global economy will have higher demand for Australian goods, which in turn drives up the AUD. Indeed, when we perform the above analysis on the AUD/USD pair, the AUD consistently outperforms post rate-cuts, thus diminishing the returns of any unhedged USD denominated exposures.

Graph: AUD Tends to Outperform Post Fed Rate-Cut Cycles

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