Gold posts its biggest 2-month drop ever. How its price could still double over the next 5 years.

By Frances Yue

Central banks aren't done moving away from the U.S. dollar, and toward the yellow metal

Gold makes up only 16% of emerging-market central-bank reserves now.

Gold prices cemented their worst two-month decline on record on Thursday, based on the price of heavily traded futures contracts.

But prices for the precious metal could still nearly double in the next five years if emerging-market central banks ramp up their push to diversify their reserves away from the dollar, according to Deutsche Bank.

The precious metal could rise to $8,000 in that time if emerging-market countries all target a 40% gold share in their reserves, even if their foreign-exchange reserves overall fall to $5 trillion, Jim Reid, global head of macro and thematic research at Deutsche Bank, wrote in a Wednesday note.

Front-month gold futures (GC00) lost 0.7% this month to settle at $4,614.70 on Thursday. They were down $615.80, or 11.77%, over the past two months, their largest two-month net decline on record, according to Dow Jones Market Data.

Gold is still up 7% year to date and 39.5% over the past 12 months. Emerging-market and developing economies were recently holding roughly the equivalent of $7.5 trillion to $8 trillion in reserves, according to the International Monetary Fund's latest annual report.

Deutsche Bank's forecast comes as investors debate whether gold's rally has come to an end. The metal has had a strong run over the past year, but its lackluster performance during the Iran conflict has disappointed some investors who expected a sharper haven bid.

Reid's argument was that the longer-term bull case for gold ultimately relies on sustained buying from emerging-market central banks. "Ultimately, we think the long-term outlook for gold will depend on the level of reserves EM central banks end up with, and the share of gold they target," he said in written commentary.

For now, gold makes up only 16% of emerging-market central-bank reserves, even though those central banks have accounted for all of the net central-bank gold purchases since 2008, Reid noted. That suggests there could still be significant room for additional buying from them, he said.

In particular, the scenario in which central banks continue buying gold could play out if there is a broader reversal of the post-Cold War order that helped cement the dollar's DXY dominance in global reserves, according to Reid.

That would mark a sharp break from the decades that followed the Cold War, when the dollar became the undisputed center of the global reserve system while gold fell out of favor with many central banks.

The post-Cold War "end of history" era, a term popularized by political scientist Francis Fukuyama in 1989, was built around the idea that liberal democracy and the U.S.-led order had triumphed, Reid said. In the 1990s and 2000s, emerging-market central banks accumulated large amounts of dollar reserves, while central banks in developed economies sold gold, he added. As a result, the dollar's share of global reserves rose sharply while gold's share fell, as shown in the chart below.

However, "the end of history has itself come to an end," Reid said. "The world is back in a superpower struggle; the U.S. is retreating from free trade, alliances and security provision; and the dollar banking system has been weaponized," he added.

That shift could make gold especially appealing to emerging-market central banks that want to reduce their reliance on the dollar without simply replacing it with another country's currency, said Juan Carlos Artigas, global head of research at the World Gold Council.

After the Asian financial crisis in the late 1990s, emerging-market central banks, many of which held the bulk of their reserves in dollars, came to see diversification as increasingly important, Artigas said in a call.

Gold became one beneficiary of that push because it is liquid, widely accepted and carries no sovereign risk, since it is not issued by any government and is "no one's liability," Artigas said.

-Frances Yue

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