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Why Gold Is Headed to US$1,000 an Ounce or Even Lower

I find it increasingly difficult to understand the attraction that gold holds for many investors. It has been one of the worst performing and most volatile asset classes in recent times, yet it continues to attract investors who believe that a massive rally is long overdue. This couldn’t be further from the truth. It is down by 6% over the last year, which means it is hovering around its lowest price in over five years, and there are signs that it has further to fall. 

Now what?

The key driver of gold’s weakness is the inevitability of a U.S. interest rate rise; the Fed is taking an upbeat view of the U.S. economy and is pointing to a December hike.

This is bad news for gold investors and miners.

You see, gold has an inverse relationship with interest rates because as rates rise, the opportunity cost of holding gold increases. This is because it is a zero-yield asset and investors receive no income when investing in the shiny yellow metal. As a result, higher rates will cause investors to exit gold and invest in those assets that have higher yields because of rising interest rates.

Another consideration is that a rate hike indicates that the U.S. economy is performing strongly, which means the U.S. dollar will continue to grow in value. This is bad news for gold, because it is priced in U.S. dollars and, as it appreciates, investors will mark down the price of gold.

The growing optimism surrounding the U.S. economy and U.S. dollar means that the demand for gold as a means of diversifying and weatherproofing investors’ portfolios will wane. This will also feed into the bearish sentiment surrounding commodities and precious metals, triggering a further sell-off that will see gold fall to US$1,000 per ounce or even lower.

Such a poor outlook for gold certainly doesn’t bode well for beaten-down gold-mining stocks. Many have seen their share prices go down by 20% or more over the last year.

If gold falls to US$1,000 per ounce or even lower, it will fall below the cost of production for many gold miners, making it even more difficult for them to remain profitable.

Then investors have to consider that many gold miners have the majority of their debt denominated in U.S. dollars. This means that a rate rise will make it more costly to service that debt, applying further pressure to already razor-thin margins.

You only need to look at Barrick Gold Corp. (TSX:ABX)(NYSE:ABX) to see the potential impact of a rate rise. It has a massive US$11.2 billion in debt, which is costing it in excess of US$500 million annually to service, and any rate hike would trigger a considerable increase in financing costs.

Nonetheless, unlike other gold miners, Barrick’s cost of production remains low, with third-quarter all-in-sustaining-costs (AISCs) of US$771 per ounce. This compares favourably with Goldcorp Inc. (TSX:G)(NYSE:GG), which reported AISCs of US$848 per ounce for the same period.

However, Goldcorp, unlike Barrick, is not heavily levered and, with its financing costs at almost a third of Barrick’s, it is not as vulnerable to a rate hike.

So what?

Despite some analysts claiming that the sharp sell-off of gold miners has left some attractively priced, this is an industry that investors should avoid. Weak fundamentals for gold, along with a potential rate hike rise, the financing costs of miners means there is limited upside available, and it is likely that the carnage among gold stocks will continue for the foreseeable future.

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Fool contributor Matt Smith has no position in any stocks mentioned.

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