Gold Ascending

One of the more curious subjects in investing is gold. It is chemically inert, difficult to extract from the earth and unlike other elements such as carbon, has limited uses. Gold was a true monetary asset at one time—the material from which mints made coinage. That was relegated to the dustbin generations ago, for multiple reasons. But, seemingly surprisingly, it appears to retain some of the same characteristics that it did when that status was official. Gold prices rise over time as governments reduce the purchasing power of their currencies, and gold has done a capable job of protecting purchasing power since Nixon severed its link to the dollar as Table 1 shows:

So it is arguable that gold has a place in portfolio construction as a diversifier, which then begs the question of what such a contribution is worth. Our purpose here is to explore that query.

It was just over two years ago that the Federal Reserve began the most stringent monetary policy in 40 years, raising its policy rate from essentially zero to over 5%. In their public statements they have been adamant that they would persist until inflation was reduced to their 2% target, and it has traveled most of the distance to that level. But only most. Recent readings have been below 4%, from highs of 7-9%, but not 2%. A question remains how hard that target is. Powell in March of this year appeared to suggest that most of their work is done, and that the target may not be as hard as it was perceived to be. Markets responded by rising, which was not a surprise.

One of those markets was gold. After responding to the government’s feverish response to Covid with higher prices, the gold price showed no real direction until March of this year, when it rose rapidly, breaching the $2,000 barrier. So far at least, it has held that level (Chart 1):

One explanation, of course, is that this is an extension of the elevated level of speculation in financial markets in general. After the stock market decline in 2022 deflated the “Everything Bubble” of 2021, it seemed that markets might be returning to less excessive behavior, but the stock market rocketed again in 2023-24. Prof. Robert Shiller’s Cyclically Adjusted Price/Earnings multiple, or CAPE, which is a measure of equity market valuation with a history that goes back many decades, is at 34. That is at the very high end of the distribution, exceeded only by the Dot-com episode, and the Everything Bubble. So speculation is active. There is, however, relatively little such excess in the gold market, at least for now, as suggested by the next charts:

This is unusual—typically there is a trend-following cohort in markets that emphasizes price momentum. They tend to add positions on rising prices, and gold has clearly been giving them reason to do so. It may be that the stock market’s persistence in optimism (at least for the time being) has persuaded them to ignore gold’s behavior.

But there is another factor to consider that is particular to the gold market. Historically the gold price tended to fluctuate with real interest rates (adjusted for inflation). In the U.S. that is measured by Treasury Inflation Protected Securities, or TIPS. The gold price has corresponded to the reciprocal of TIPS yields, since gold does not yield interest payments, which rise in value as interest rates do. Gold tends to fall in price as rates rise, hence the reciprocal relationship. This was a reasonably reliable pattern, until now (the TIPS yield is inverted in the chart below to demonstrate the relationship):

The gold price has risen, not fallen as real rates rose—the opposite of past periods.

The question, of course, is why. A strong candidate is a change in the behavior of one particular participant in the gold market, which is central banks. Governments have long held stores of gold even after gold coinage fell out of practice. Some of this is historical. The U.S. in particular holds the large store of gold as a legacy of the days of the gold standard, which at one time allowed residents to redeem their dollar notes for physical gold (a practice that was gradually abandoned and ended entirely in 1971). At the other extreme is Zimbabwe, which after many years of inflation and resulting monetary debasement is apparently issuing a gold-backed currency (there is doubt about the sustainability of the practice, but we shall see).

In any case, governments have increased their gold purchases. The World Gold Council tracks the data, which show that after a long period of divesting gold reserves, their activity changed to acquisition, the consistency of which is material (Charts 5 and 6):

It would be simplistic to attribute the price behavior of gold solely to central banks. There could be any number of factors that have caused the price to reach a new level. But they share one attribute that other buyers do not. Their motives are not profit, but economic policy. They are what is known as “price inelastic”—the price they pay is less important than achievement of their policy goals. So it would appear that this change in the behavior of a differentiated participant in the gold market can help explain the move in gold to new price levels, and unless their policy decisions change to the disadvantage of the gold market, such prices appear to be sustainable.