Is the Gold Price at a Turning Point?
Is the Gold Price at a Turning Point?
Analyzing the shifting dynamics of gold pricing in an era of war, inflation, and monetary instability
Gold is in a transition phase. In the past nine months two key developments—war and inflation—have made gold trade much stronger than how it was priced from 2006 through 2021. Both developments are likely to stick around in the coming years and will prove a tailwind for gold. Moreover, the current monetary environment is adding support to the gold market as governments and central banks risk insolvency.
For the medium- and long-term I'm therefore optimistic on gold. In the short-term gold still has downside risk due to rising interest rates and the possibility of collapsing asset markets triggering a liquidation event.
Analysis Overview
Understanding TIPS Yield Correlation
From 2006 until early 2022, the market priced the U.S. dollar gold price based on the 10-year TIPS yield, which can be seen as the expected real interest rate on 10-year U.S. government bonds, and dollar strength. Understanding this relationship is crucial for anyone looking to invest in gold strategically.
The correlation between gold and the TIPS yield is inverted because the lower the TIPS yield (expected real rate) the more investors are incentivized to buy gold and vice versa.
Key Market Insight
We can see that until recently the correlation was tight. From 2014 until 2017 the gold price traded below the TIPS yield because of a strengthening dollar. Remarkably, since the war in Ukraine gold is not only trading firmly above the TIPS yield, it's doing so while the dollar is going up.
War and Gold Market Dynamics
The first development that has changed how gold is priced is Russia's invasion into Ukraine, which set in motion a proxy war between the West and Russia. As ties between the U.S. and China are also deteriorating, it can be expected the division between East and West will accelerate.
De-dollarization Trend
- Eastern nations reducing dollar reserves
- Search for alternative store of value
- Gold's appeal as non-political asset
- Five thousand year track record
Supply Chain Impact
- Declining East-West trade
- Production reshoring trends
- New supply chain creation
- Inflationary pressure buildup
Watershed Moment
The war made the U.S. decide to freeze dollar assets owned by the Russian central bank. This watershed moment has startled all foreign holders of dollars. Countries in the East holding large dollar reserves are warned their assets can be rendered worthless in the blink of an eye.
Sovereign wealth funds and other investors are buying gold because there aren't many alternatives for the dollar. Gold isn't issued by any country or central bank, and thus has no political or credit risk, it's in limited supply, it's untraceable, and has a five thousand year track record as a store of value.
Central Bank Gold Purchases
Recently the World Gold Council reported central banks bought close to 400 tonnes of gold in Q3 2022, which is four times as much compared to Q3 2021 and a record since the end of Bretton Woods.
This massive purchasing activity reflects institutional recognition of gold's value as a monetary asset. For investors seeking exposure, purchasing physical gold allows participation in this same trend.
Inflation's Impact on Gold Pricing
Some investors are disappointed by gold's performance this year because the price in dollars is down while consumer prices in the U.S. have increased by 8% year-on-year. What they fail to see is how gold was priced in recent years—based on the expected real yield—and how that is changing.
Market Transition
Now inflation is showing to be sticky, and the world is de-globalizing, gold seems to be in a transition phase. Some entities sell gold based on the old model; others are buying based on a new model.
Why Inflation Will Remain Elevated
Historical Analysis
Deutsche Bank analysts researched 318 episodes across developed and emerging markets since 1920 in which inflation reached 8%. The team concludes we have passed the point of no return:
"Once inflation spikes above 8%, median inflation takes around 2 years to even fall beneath 6%, before settling around that level out to 5 years after the initial 8% shock."
Policy Response
From Deutsche Bank analysis:
"You could argue this is the loosest policy response to inflation we've ever seen in peacetime... However, the current consensus expects us to be back at or even below 3% just two years after we initially moved above 8%."
Government Credit Guarantees
Since the pandemic several governments have taken control over the printing press through loan guarantees:
- Germany: 40% of new loans guaranteed
- France: 70% of new loans guaranteed
- Italy: Over 100% guarantee coverage
Energy Transition Costs
- Declining oil discoveries
- Global recoverable oil down 9%
- Tight oil markets ahead
- Commodity price pressures
Central Bank Insolvency Risk
After 40 years of moderate inflation Wall Street is conditioned thinking inflation will always swiftly revert to 2%. This reflects strong confidence in central banks and governments. But is this confidence misplaced?
European Banking Crisis
In Europe, for example, Italy has so much public debt that the ECB has virtually been the only buyer of Italian government bonds in recent years. So how is the ECB supposed to tighten (sell Italian government bonds) and hike rates without Italy going bankrupt?
Central banks that conducted Quantitative Easing (QE) in the past years and now raise rates are suffering losses due to increasing interest expenses on their liabilities. The Dutch central bank is making losses that will have a severe impact on its equity (capital). But other European central banks, the Bank of England, and the Federal Reserve have the same problem.
Three Scenarios for Central Banks
Scenario 1: Negative Equity
Operate under negative equity and risk people lose confidence in the currencies issued by these central banks.
Scenario 2: Recapitalization
Treasuries (taxpayers) recapitalize central banks' equity. Though this option is difficult because of the currently high public debt levels.
Scenario 3: Gold Revaluation
Use the central banks' gold revaluation accounts to increase equity, which requires a floor under the gold price and possibly revaluing gold.
Market Implications
The theory of revaluing gold has gone mainstream after renowned financial journalist Ambrose Evans-Pritchard mentioned it in The Telegraph. Markets might anticipate a gold revaluation and buy gold accordingly. Additionally, they might buy gold as a safe haven for when sovereigns default and cause contagion in financial markets.
Market Outlook and Conclusions
There is a plethora of challenges in global finance. Previous to 2022 such challenges could temporarily be resolved by QE and zero interest rate policy (ZIRP), while fundamentally making matters worse: debt levels kept going up. Due to inflation these options are lethal. There is no easy way out anymore.
Perfect Storm Elements
- Geopolitical tensions escalating
- Persistent inflation above targets
- Central bank solvency concerns
- Currency system instability
Investment Implications
- Gold's role as monetary anchor
- Potential price revaluation ahead
- Portfolio diversification benefits
- Long-term wealth preservation
Consider adding gold to your portfolio as these dynamics unfold.
Strategic Positioning
War, inflation, and solvency risk could be a perfect storm for gold. For investors seeking to understand these dynamics, monitoring gold price movements alongside silver market trends provides crucial market intelligence for timing strategic precious metals allocations.
Disclaimer: This analysis is for educational purposes only and should not be considered financial advice. Precious metal investments involve risk, including potential loss of principal. Past performance does not guarantee future results. Always consult with qualified financial advisors before making investment decisions.