A primer on gold, part 2 - What drives the price?
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In part 2 of my primer on gold, I’ll cover the three main factors that drive the market price of gold. You can find part 1 here:
Part 1 was just an appetizer - part 2 is where I dig deeper into my mental model for how I trade gold.
The financial press calls gold a hedge against inflation, but the more accurate description is that it’s a hedge against inflationary monetary policy. When inflation exploded in 2022, gold traded in a $1600 to $2070 range. If you didn’t buy gold when the Federal Reserve sowed the seeds of inflation by cutting interest rates to zero and conducting record quantitative easing, you missed the 42% uptrend that sent gold from $1450 to its high of $2070.
During my career of watching and trading gold, I’ve observed three distinct regimes (how gold behaves relative to other assets) that gold spends time in. The most common and therefore default regime is when gold tracks the looseness and tightness of US monetary conditions.
Historically, the price of gold has been positively correlated with the size of the Federal Reserve’s balance sheet. QE after the GFC and March 2020 sent gold to new highs. One exception to this relationship was in 2013, when the balance sheet expanded but gold trended lower due to the bond taper tantrum and expectations of tighter policy. The other exception was in 2019 when the balance sheet contracted from QT but gold rallied due to weakening economic data and expectations of monetary easing. Today’s backdrop is the most similar to 2019 in the sense that economic data is weakening and the market expects a Fed easing cycle next year.
Real Treasury yields are a more real-time and accurate indicator of how loose or tight monetary policy is. Gold has tracked real 10 yr Treasury yields pretty closely in the post-GFC era, and they often take turns leading or lagging each other. In the chart above, you can see that the Fed tightening cycle since 2022 has seen the relationship between gold and real yields break down. I’ll get to why that is later in the post.
On shorter time frames, gold has a higher correlation with nominal 10 yr yields. The correlation between gold and nominal yields has been roughly 0.30 going back to 2008. Events that push yields lower, such as downside economic surprises and dovish central bank announcements, tend to push gold higher. In the chart above, you can see that gold has exhibited a strong upward drift relative to yields, especially in 2023.
Gold has the tightest correlation with USD FX, with a correlation of 0.47 since 2008. If one zeroed in on the FX pair that historically has had the tightest correlation to gold, it would be usd/jpy. The chart above shows, like the previous ones, a strong upward drift in gold relative to where DXY suggests it should be.
Central bank purchases of gold
Central bank purchases of gold soared to record levels after Russia’s invasion of Ukraine. Turkey, whose central bank is dealing with perennial currency crises and inflation, purchased the most gold out of all the central banks in 2022, followed by China. Since Q3 of 2022, China has taken the lead as the largest buyer.
The likely reason behind China’s aggressive purchases of gold is the precedent the US Treasury set when they shut out Russia from the dollar-based international financial system, effectively freezing their USD holdings. China’s move to increase their gold reserves helps insulate them from US financial sanctions in the event a full-out economic or military war breaks out between the China and US. Most gold watchers would agree that the increased pace of central bank purchases has been the driving force behind gold’s resilience in the face of higher yields, higher USD, and Fed QT.
The 8.6m troy ounces of gold China purchased since last September has only boosted gold’s share as a percentage of its foreign reserves from 2.9% to 4.1%. Nobody knows what percentage they are targeting, but they have a long way to go before gold can meaningfully insulate their reserves again US sanctions. China is showing no signs of slowing down their purchases for now.
The second most frequent regime that gold spends time in is when it is reacting to geopolitical shocks. Most recently we saw gold surge after the Oct 7 attacks on Israel by Hamas. Gold gained a significant geopolitical risk premium above where USD and Treasury yields suggested it should be trading.
Once fears of a wider Middle East conflict receded, the geopolitical risk premium closed from roughly $180 to $80 (my estimate). Some of that premium has remained sticky, perhaps due to central bank and CTA purchases.
Gold spiked from 1888 when Russia invaded Ukraine on February 24, 2022 to as high as 2050 two weeks after. However, the geopolitical risk premium closed quickly as the market shifted its focus towards tightening Fed policy, which you can see in the chart below. Yields and USD were rising as the market came to grips with inflation fears, and that sent gold reversing back lower as the regime shifted back towards tracking monetary policy.
Every once in a while, volatility explodes, and the markets undergo a severe deleveraging process where most market players trying to raise cash. In periods like this, gold tends to sell off as violently as every other asset, despite its reputation as a safe haven.
An example of this was during March 2020, when equity markets sold off violently and VIX spiked above 80. A VIX index above 50 was the threshold at which gold holders were compelled to liquidate into USD.
The other example in recent memory was during the Great Financial Crisis when VIX rose above 50 and stayed there for weeks. Gold sold off sharply during that episode as well. Looking back on both periods, gold was a high conviction buy during those periods of stress, as the crises forced the Treasury and Fed to respond with powerful monetary easing, setting up a bull market for gold in the months to follow.
Trading regime transitions
When gold transitions between regimes, traders can find reliable setups. A transition out of a volatility shock back into the default regime doesn’t happen very often, but can be very profitable when it does. In both 2020 and 2008, the selloff in gold reversed once VIX retreated lower, and gold started to follow financial conditions again, which were looser due to the Fed cutting interest rates. Buying the dip created a great entry point to the next bull market.
Fading geopolitical spikes can also be lucrative. The spike in March 2022 after Russia invaded Ukraine faded quickly, as the market shifted its focus back to inflation and the need for Fed tightening.
Gold as an asymmetric way to position for loosening monetary policy
Central bank purchases of gold have ramped up over the past year, and should continue for some time. The purchases made gold resilient in the face of tightening monetary conditions and a rise in USD, therefore cushioning the downside for gold investors. In the short term, gold has delivered stronger volatility-adjusted performance than Treasuries and FX for those expressing a view on dovish monetary policy or downside economic surprises. Longer term allocators can benefit from the asymmetric return profile that results from continued central bank support. When the Fed pivots and ends QT, a new bull market in gold should resume.
Part 3 discusses gold vs bitcoin, and how gold can be a signal for what bitcoin does next.
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