Gold: A Change in Market Dynamics?

Against the backdrop of resurgent equities in recent months, the price of gold has risen from $1500 per troy ounce to record nominal highs above $2000 [1]. Given its rally in tandem with stock market recoveries, this rise has bucked significant historical trends and correlations between equities and gold – indicative of the current era of financial markets where the Fed has proven once again that is has the ability to cause paradigm shifts in capital markets. Understanding the reasons behind gold’s recent rally – and whether it is set to continue – is important. Not only for portfolio reasons, but for understanding whether the dynamics of the gold market are changing.

Gold has rallied to over $2000 per troy ounce in recent months [1].

Why Invest in Gold?

Despite its depressed macroeconomic importance due to the phased abandonment of the gold standard in the twentieth century, gold has been and still is an important safe haven asset for investors. As well as being important for investors, many governments and central banks hold gold deposits as part of their reserves (Gordon Brown was highly criticised for his instruction to sell gold reserves before a significant rally at the beginning of the century when he was Chancellor of the Exchequer). Directly unrelated to interest rates and a store of value due to its finite state, gold – as well as other assets such as the US Dollar, Swiss Franc, Japanese Yen and developed market debt – is a safe asset during any equity market turmoil. This almost “inverse” relationship between the two has led to portfolio diversification patterns.

Additionally, the presence of inflation (a rise in the economy’s price level) erodes the real value of debt interest (and hence government bond yields). Via the formula:

real interest rate = nominal interest rate – inflation rate

The real interest rate falls with an increase in inflation assuming a constant nominal interest rate. Although gold has no yield or income, rational investors would rather hold an asset that returns no income compared to one that returns a negative yield.

Another explanatory asset correlation for changes in gold prices is the US Dollar. Although typically seen as a safe asset itself, a depreciation of the US Dollar is often translated into bullish gold sentiment due to the decreased relative price of gold for holders of foreign currency (gold is priced in US Dollars).

A Golden Age

As one can see from the graph below [2], significant recessionary periods such as the great depression and the great recession after the financial crisis preceded significant increases in the price of gold, showcasing the first explanation for gold’s value for investors.

Conversely, the recessionary period in the late 1970’s and early 1980’s was accompanied by rising inflation – a macroeconomic state labelled “stagflation” which signalled a rebuke of Keynesian macroeconomic theory that – as stated by the Phillips Curve – described inflation and recession as mutually exclusive. The double effect of a recession and presence of high inflation led the price of gold to increase from $517 in October 1976 to a record real (inflation-adjusted) value of $2247 in January 1980. The rise was indicative of the macroeconomic environment which precipitated the fall of Keynesianism and its replacement by Monetarist Theory; Ronald Reagan and Margaret Thatcher were then elected on a new economic agenda.

Nominal gold prices over time [2]

What Explains the Recent Rally?

There are probably three main reasons which best explain gold’s rally since March: the economic damage wreaked by COVID-19; the monetary response to that; and the depression of bond yields henceforth.

There are no two ways about it: the pandemic will cause one of – if not the most – significant economic contractions on record. Various social distancing measures and mitigation procedures have dealt hefty blows to the world economy, leading to predictions that GDP levels will not reach pre-pandemic peaks until the end of 2021 – US GDP figures released last week revealed a 32.9% decline YoY in the second quarter [3]. Unemployment recoveries are expected to be slower than the last crisis, creating a significant lag when attempting to close output gaps. Therefore, it has been a natural reaction for investors to seek safety in gold over the recent months, especially given the uncertain nature and timeframe for a vaccine which could exacerbate the already anxious recessionary environment.

The Federal Reserve’s response to the crisis was strong and impactful: the US central bank committed to buy US Treasury bonds en masse, before implementing similar operations in other credit markets. The aim: to reduce borrowing costs for all economic agents to mitigate the effects of the ensuing economic contraction. By bidding up the prices of government bonds (a safe haven), the Fed’s market activity is predominantly responsible for a large depression of yields (yields are inversely related to price), as shown below [4]. With there being little room left for an additional rally in the bond market, investors have increased their gold holdings.

Yields have fallen significantly in recent months, reflecting the bond rally [4].

The relationship between the US Dollar and gold is also partially responsible for the rally. As investors have relatively soured towards the Dollar since March (the US Dollar Index is down 9.2% since then; it has fallen by over 10% against the Euro and even against British Sterling) foreign investors have most likely increased their gold holdings. With the US currently in the midst of a second round of lockdowns having failed to stop the spread of the first wave of the virus, US macroeconomic data is likely to portray a still pessimistic outlook, bringing bearish sentiment for the dollar – and good news for gold. Additionally, the dovish monetary policy adopted by the Fed – which is likely to continue over the next few years, could also lead to a weaker Dollar.

Will the Rally Continue – And Have Market Dynamics Changed?

With dovish monetary policy in place for the foreseeable future, nominal yields should expect to be depressed and hence a continuation of bullish gold sentiment is probable. With an eventual economic recovery also in place, an inflationary environment is also likely to return. This is corroborated by the spread between inflation-adjusted US Government bonds yields and the nominal yields of normal Treasuries – known as the 10-Year Breakeven Inflation Rate. It has steadily risen over the last few months (below) [5], further reducing real yields into negative territory. With real yields expected to remain negative for the foreseeable future, investors could push further into gold. A typical proxy for the value of gold is its ratio with the monetary base – which stands at a value of 0.34. It has previously reached values of 5.31 and 4.84 in gold rallies [6].

Inflation expectations have increased since bottoming out in March [5].

As for market dynamics, the gold rally has been fairly predictable and the breakdown in typical negative correlation with equities is more of an equities issue. Despite an obvious hit to fundamentals and operations, equities have entered the recent earnings season having made up lost ground, with the S&P 500 beating its pre-pandemic peak in recent weeks. With capital markets awash with an increased money supply from the Fed and the perhaps over-optimistic view of a V-Shaped recovery, equities have rallied alongside gold. The similar positive correlation was present when there was a large scale selloff in all markets in March, as investors realised the damaging potential of the virus. Dynamics in the gold market have certainly not changed, but to question the breakdown in the relationship between gold and equities – and why that has happened – would be wise.