A golden age for gold?

Golden age for gold

In the past two years, almost no asset class has outperformed gold. But what drives the price of gold, and does the recent correction in the all-time highs offer a chance to buy?

The total global amount of above-ground and underground gold reserves is estimated at around 250,000 tonnes. About 198,000 tons of this has been mined so far. If this amount were to be melted down into a cube, each side would be 21.70 meters long. At the price of $1,910 per troy ounce (31.103 g), this cube would be worth $12.8 trillion. For comparison, this is roughly the equivalent of the combined expansion of the Fed and ECB balance sheets over the past twelve years (about $12 trillion).

It is clear that gold does not generate cash flow and has no real, measurable benefit. Holding gold only costs money – because of storage costs – which means that it causes a negative cash flow. So whether you consider gold as a currency, a commodity, an asset class, or a consumer good, there is currently no theoretical model to calculate a fair price for the precious metal.

It is not surprising that this observation is one of the main criticisms of gold opponents and is not considered a shortcoming for anything. That being said, as long as gold fulfills its role and retains its value, it automatically has a cost. The advantage of gold over fiduciary money as an alternative means of value and exchange is its limited supply. Unlike conventional currencies, gold cannot be printed just like that.

The Price of Gold and Interest

What determines the price of gold? In recent years there has been a certain degree of stability on the supply side. Relative fluctuations on the demand side have been most significant at the investment and central banks.

Given the gold miners’ current available capacity, it is unlikely that the supply of gold will change drastically. Therefore, imbalances in this ratio can be expected mainly on the demand side, and in particular, on the investment side.

On what does the investment demand, and thus the price of gold depend? The most obvious factor, for which there is also a very plausible explanation, is the gold price dependence on real interest rates.

The reasons for this can be summarised as follows: if a sufficient number of market players attribute the functions of security of value and exchange to precious metal gold, as well as free trade and ownership, gold should be considered as a valid alternative to paper money.

The purchasing power of money depends, in simplified terms, on the nominal interest rate minus inflation, i.e., the real interest rate. Since this correlation does not apply to the “purchasing power” of gold, the price of gold – calculated in paper money – should move inversely to the real interest rate.

It is then up to the broad community of investors to put this theoretical construction into practice. They determine the price of gold through their trading activities in a continuous assessment of money and gold’s relative attractiveness.

To answer how the price of gold will develop in the future, it is therefore essential to look at the real interest rate changes.

We know that paper money is generally controlled by independent central banks to guarantee guaranteed relative price stability. Most countries face chronic deficits in their national budgets. The fiscal measures taken to combat the current Covid-19 crisis represent an interim peak in a trend towards global government debt that would be unsustainable without record low nominal interest rates and the so-called monetization of government debt (the central bank’s purchase of government bonds).

Now that the major central banks have decided that nothing will change in the short term about low-interest rates and the quasi certainty that the rapid expansion of the money supply through the monetization of public debt will have an inflationary effect, we will continue to see a further decline in real interest rates in the coming years. This should answer the question of the direction in which the price of gold will evolve.

However, it is much more difficult to say what the absolute price will be. On the one hand, even the most recent so-called gold bull runs had interim corrections of 25% and more. On the other hand, even after beating a long-term record, the gold price has still doubled, if not tripled. The cost of gold may rise further than is currently considered possible, especially if inflation is very high.

Add Gold as an Asset

With a clear view of the real interest rate, a gold position geared to risk appetite should be part of the asset allocation. The observation – especially recently – that there is a strong correlation between the share price and the gold price, to the detriment of the desired diversification effect, although not insignificant in the short term, is not relevant in a long time. In principle, both assets have significantly benefited from the fall in interest rates in recent years.

However, if there is a sharp rise in inflation – which is not in line with expectations – gold will behave differently from equities in the long term. The same applies in an environment of falling equity prices if interest rate movements do not cause this. If this were to happen, one would need gold in addition to or even instead of equities.