If You Think Owning Gold Is Waiting for Godot, Think Again

Four decades on and inflation has returned. After remaining inert for too long the Federal Reserve sprang to action and began raising interest rates, with accelerating vigor in just a few months’ time. That had effects across financial markets that were significant. One of those was gold.

Gold has not kept up with the many asset classes that thrived in the last decade. That period, in fact, has been referred to—at least by skeptics—as the “Everything Bubble”. The valuations on many of the principal asset classes met or exceeded historical precedents. Common stock valuations may have looked unattractively high by historical standards, but relative to bonds at yields never seen before they were in many cases not unreasonable. This does not give a full measure of the excesses in financial markets in the last several years, of which cryptocurrencies were among the most egregious.

So, despite its longstanding tenure as a financial asset of some merit, gold has not kept up. In Charts 1 and 2 we show its performance relative to stocks and residential real estate:

Despite its strong performance early in the pandemic, the Fed’s belated response has caused gold to underperform the Consumer Price Index recently, as shown in Chart 3:

But to put this in historical perspective, gold has played a role in financial markets for a very long time. Since the end of gold’s convertibility into U.S. dollars in 1971, its place in financial markets has diminished, but has not disappeared. To the occasional disappointment of fans of fiat currency, its relegation to a secondary role in monetary affairs has given gold the status of a shadow measure of confidence in the managers of the fiat system. It tends to rise in value as the authorities behave in ways that threaten the purchasing power of the currency and fall when they do the opposite. The Fed’s recent conversion from lassitude to resolute protector of the dollar’s purchasing power has thus reduced gold’s price, although by late fall the gold market was so gloomy that some relief was due, as shown in Chart 4:

This level of central bank vigor has not been seen since the Paul Volcker Fed set out to subdue double-digit inflation in 1980 and 1981and has been a headwind for gold in western financial markets.

But outside the markets dominated by developed-world central banks, it is another story. Gold’s place in the financial system has traditionally included status of a haven, supported by material quantities owned by central banks. Despite all the innovation in recent years this has not changed. The absence of governments and their central banks has been the primary flaw in the cryptocurrency phenomenon and is now part of their trouble. Gold, on the other hand, continues to attract their interest. Central bank purchases in the third quarter were the highest in recent history (Chart 5):

It is possible, or even likely, that this activity was motivated in part by the decision by the G7 group of countries and the European Union to freeze the Russian central bank’s fiat currency reserves shortly after that country’s invasion of Ukraine on February 24 of last year. That represented over one half of Russia’s total international reserves. Countries outside that group may have concluded that participation in a dollar-based monetary system had been a mistake. The alternatives may have shrunk as a result.

Information from the futures market is also interesting. There are various kinds of participants, from investors to speculators, and those who trade in the commodity as part of their daily business. In the gold market that includes jewelry firms, mining and processing firms and others who own physical gold as part of the business. The latter are referred to in the trade as “commercials”. To reduce the risk of price fluctuation on their inventory, they sell futures “short” to counter the “long” risk in their inventory. The Commodity Futures Trading Commission collects data on this activity, which can be considered as an opinion of the direction of prices. Commercials are known in the trade as “smart money” because they have historically been buying (to reduce their short position) at times that had been an indicator that prices are about to rise. The recent data is encouraging for holders of gold (Chart 6):

In Samuel Beckett’s play Waiting for Godot two characters converse at length while waiting for a character, Godot, who never arrives; it is a metaphor for waiting in futility. To some observers this appears to resemble the recent experience of gold owners. But the Fed’s decisions usually have unintended consequences, and the sharp tightening of monetary policy in 2022 is a candidate for repeating that history. While any asset can spend time in the wilderness, when this cycle of tightening ends expect gold to surprise on the upside.