Although rising bond yields and an impressive rally of the US dollar have limited gold's upside, it remains an essential safe-haven asset for investors, according to one commodity analyst.

In a recent interview, Nitesh Shah, head of commodity research at WisdomTree, said that although gold has been in a downtrend throughout 2022, the precious metal is holding up relatively well.

Last week, gold slumped to a 2-year low while the entire market was down by nearly 12% since the start of the year. This week, the precious metal has seen a short-covering rally pushing prices back above $1,700. So, gold managed to cut losses to 6% since the start of the year.

Shah said that according to his modeling, given how far bond yields have risen this year and the US dollar's rally to a 20-year high, gold prices should be down by 21% this year.

"I know some people have been disappointed with gold, asking why prices aren't higher given where inflation is but against this setup, gold is doing pretty well," he said.

According to the expert, the growing divergence between the physical market and the paper market is the reason why gold has performed well in the current environment.

The latest data from the Commodity Futures Trading Commission shows that bearish positioning in the gold market has been at its highest level in four years. This puts pressure on paper markets.

While institutional investors have left the gold market, retail investors are joining the game to buy physical gold. Shah noted that prices for gold and silver remain rather high, indicating a tight physical market.

"The physical market is providing a lot more support to the market than we might actually think," he said. "This is similar to what happened in 2013 when falling future prices unleashed major demand for the physical metal."

The analyst noted that China still has a healthy appetite for the precious metal as the country does not have enough gold to meet the demand. In September, the benchmark gold price on the Shanghai Gold Exchange rose by $43, above the benchmark set by the London Bullion Market Association.

The record-high prices come as Chinese gold imports rose to a four-year high in August.

Along with retail demand, unreported central bank purchases could also be provided support for the precious metal. For example, the Russian central bank is buying domestic gold production as western sanctions have cut off the nation's access to global markets.

China's central bank is probably buying more gold as well.

Although paper gold prices are expected to struggle in the near term, Shah said that he remains optimistic that prices will start to rise in 2023, rallying back above $1,900 by the third quarter.

"I don't think inflation is going away. I don't think central banks will be particularly successful in stamping out inflation and that will continue to be good for gold," he said.

Although the Federal Reserve is expecting to raise interest rates in 2023, the analyst expects them to peak in the first half of the year. However, he sees inflation holding around 5% through the third quarter.

In this environment, investors will once again see gold as an important inflation hedge.