Spot gold recorded its largest weekly decline since March 2020 this week, with the main sell-off occurring during Asian and European trading hours. Significant movements in cross-currency basis and swap spreads suggest a sharp increase in global demand for US dollar funding. Amid speculation of tightening dollar liquidity, investors may have been forced to sell gold to raise cash.
This week's historic sell-off in gold, as indicated by market metrics, may be driven by a rapid rise in global dollar funding needs. Spot gold fell approximately 8.5% this week, marking its worst weekly performance since March 2020. At one point during the session, the decline reached 10%, which, if sustained, would have been the largest weekly drop since 1983.
Notably, the steep decline in gold this week primarily took place during Asian and European trading hours. This pattern has fueled speculation that the plunge in gold may be an early warning sign of an emerging dollar funding crisis.
Initial signs of rising dollar demand are appearing, with underlying liquidity in the global financial system beginning to show stress. According to observations by UBS traders, considerable volatility has been noted in the cross-currency basis for JPY/USD and CHF/USD.
The cross-currency basis is a key indicator of the cost for non-US institutions to obtain US dollars. A widening basis typically signals higher costs of accessing dollars in offshore markets, indicating increased global demand for the US currency. When facing dollar shortages, investors often prioritize selling highly liquid assets, such as gold, to secure much-needed US dollar cash. Suki Cooper, Head of Global Commodities Research at Standard Chartered, noted that liquidity demands in other areas, like the US dollar, continue to suppress gold's geopolitical risk premium.
Beyond cross-currency basis, other indicators measuring potential stress in market funding channels are also signaling pressure. Swap spreads have widened significantly.
Widening swap spreads often reflect tightening bank balance sheet capacity or increased market concern over counterparty risk. These developments, along with market logic, point to the possibility that global markets may be experiencing a degree of tightening in US dollar liquidity.
If dollar funding pressures continue to rise, they could influence the monetary policy of the US Federal Reserve. Current market pricing indicates that investors expect no interest rate cuts from the Fed this year.
However, according to Bloomberg, several sizable bullish flows have recently appeared in the SOFR options market. These trades appear to be hedging against tail risks, effectively betting that the Fed may implement up to two 25-basis-point rate cuts within the coming weeks.
Such hedging behavior suggests that some market participants are guarding against the risk of a sudden liquidity event forcing the Fed to take emergency action. Although there are no signs yet of widespread use of the Fed's emergency liquidity facilities, such as the discount window, underlying market dynamics are undergoing subtle shifts.
Gold is also under pressure from hawkish signals from global central banks. Analysis suggests the core driver of this gold downturn is a reversal in interest rate expectations, as several central banks in the US and Europe have issued hawkish signals. Conflicts in the Middle East have triggered sharp increases in crude oil, natural gas, and fuel prices, raising concerns about the global inflation outlook. Since gold does not generate interest income, reduced expectations for rate cuts directly diminish its relative appeal.
At the same time, retail investors have been net sellers of gold ETFs for several consecutive sessions, and CTA hedge funds have actively reduced long positions, exacerbating the sell-off due to liquidity pressures.