Why Gold’s 14% Q2 Drop May Be a Healthy Correction Amid Central Bank Support and Inflation Risks

Central bank demand will push gold prices higher in 2026. Despite the second quarter being the worst for gold in 12 years, as a sharp rise in energy prices increased inflation expectations and created the possibility of interest rate hikes, central bank demand will help gold finish the year on a positive note, according to a new quarterly forecast from Invesco.

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Gold fell 14.1% in the second quarter, erasing the first quarter’s gains and dropping more than $1,500 below the all-time intraday high set in late January. Volatility increased in April, but most of the decline occurred over the following two months.

On June 24, the yellow metal dipped just below $4,000 for the first time since November 2025. It fluctuated around this psychologically important level in subsequent days and ended the quarter at $4,008. This is the worst quarter for gold since the second quarter of 2013, when the price fell 22.7%, but such corrections are not uncommon when any market has been rising so sharply for an extended period. This latest price correction could be useful given that gold has still risen 21.3% over the past 12 months.

However, downside risks to gold prices remain. The next few months could be crucial for gold as we watch how the Fed responds to inflation (whether inflation will be persistent or decline with falling oil prices) and whether the US dollar strengthens against other major currencies.

Higher interest rates and a stronger US dollar typically negatively impact gold, as the former increases the opportunity cost of holding a non-yielding asset and the latter makes gold more expensive for international investors. Several factors negatively impacted gold prices during the quarter. Inflation has become a threat that could potentially persist longer than previously anticipated, meaning interest rates could stay high for longer. The US dollar strengthened, albeit slightly, partly in response to the revision of interest rate forecasts. Finally, some geopolitical risk premiums were removed from the perceived safe-haven asset as the market appears convinced that US-Iran negotiations are moving toward a satisfactory outcome. The impact of the conflict on energy prices has led the market to focus on inflation.

The easing of inflation expectations indicates that the market generally believes recent inflation will be brought under control. The question is whether the market is being overly optimistic given recent actual inflation data and the ongoing potential instability in US-Iran relations. PCE inflation in May reached 4.1%, the highest since April 2023, mainly due to high energy prices, but core PCE inflation, excluding food and energy, also reached 3.4%, the highest since October 2023.

The FOMC, under new Fed Chair Kevin Warsh, warned the market in minutes following the April committee meeting, stating it would “ensure price stability” after inflation remained above the 2% target for five consecutive years. Invesco analysts said the recent gold price correction can be seen as a reasonable response to rising inflation expectations, the Fed’s more hawkish stance on interest rates, and the recent strengthening of the US dollar.

The US dollar weakened early in the quarter but strengthened against its major trading partners for most of the period. This makes gold more expensive for international investors and consumers, which tends to reduce demand from these important segments. After widespread expectations of further rate cuts, rate hikes are now forecast for 2026.

Earlier this year, the futures market predicted Fed rate cuts in 2026, with the only question being how many. The CME FedWatchUS tool showed almost zero probability of rate hikes this year. Then the inflation pressure changed market expectations, and the Fed under new Chair Warsh appears more committed to addressing persistently above-target inflation, making rate hikes a firm agenda item.

By end of May, the market virtually ruled out rate cuts in 2026 and began considering rate hikes. When the quarter ended, the market assessed a 33.7% probability of a 25 basis point hike by end of July and a 67% probability of at least one rate hike by the September FOMC meeting. According to the CME FedWatch forecast, the probability that interest rates will be higher than current levels by year-end is 83%. Higher interest rates negatively impact gold by increasing the opportunity cost of holding a non-yielding gold asset. Despite rising inflation expectations, potential rate hikes, and recent weakness in the precious metal, Invesco maintains a constructive outlook for gold in the second half of 2026. They believe much of the structural support for gold remains largely unchanged.

Central banks appear to continue buying gold to diversify their reserves. The GOLDCOUNCIL reported that a record 45% of central bankers responding to its latest survey said they expect to increase their gold reserves over the next 12 months, while 89% expect an increase in global central bank gold reserves over the next year. This structural support was reflected in their recent Global Sovereign Asset Management study, where most central banks reported increased gold allocations over the last three years, with concerns about global volatility, inflation hedging, and geopolitical uncertainty now among the top drivers of ongoing gold purchases.

While central bank demand is largely price-insensitive, investment demand is sensitive to price dynamics. Rising prices can attract inflows, but falling prices can sometimes stimulate sales, especially when an investor can lock in profits and needs liquidity to reallocate to other assets. Retail purchases of coins and small gold bars have been a strong source of demand throughout the long-term rise in gold prices, and it will be important to see how they respond to the correction. For retail and professional investors, the case for including gold in a portfolio is not based on a single consideration, such as using it solely for geopolitical hedging, though gold has historically performed relatively well in that role. Rather, gold can be a useful diversification tool because it tends to have low correlation with most assets, especially equities. Gold is a unique asset with no issuer, no credit risk, and a long history as a store of value when confidence in currencies, institutions, or market structure is questioned.