Uncommon truths: Why is gold so expensive?

Gold is approaching long-term historical real peaks, recently helped by US crises. We think inflation, geopolitics and falling cryptocurrencies may help explain why it held up so well in 2022, despite the rise in real yields and the dollar. However, those factors may prove ephemeral. 

Gold has been among the better performing assets this year and continues to hold up well (see Precious Metals in Figure 3). That it is doing so well in the face of US problems (mini banking crisis and government debt ceiling saga) should come as no surprise. Nor that it has gained nearly a quarter since the low of late September 2022, since when US treasury yields and the US dollar have fallen (we were Overweight gold in our Model Asset Allocation since mid-November but reduced it to zero in mid-March – see Figure 6). 

Harder to explain is why it did so well last year in the face of a sharp rise in real treasury yields and an appreciating US dollar. While our model based fair value for gold fell below $1000 in 2022, the actual price ranged between $1620 and $2050 (the model based fair value is currently around $1000). Our econometric model is based on the historical relationship between gold and three variables: real US treasury yields (the 10-year TIPS yield), inflation expectations (the 10-year US treasury inflation breakeven) and the trade-weighted US dollar. We also introduced a dummy variable in November 2016 to capture the sudden boost to gold that came at around the time that President Trump was elected (see Could gold reach $7000?). All explanatory variables were statistically significant.

Maybe there has been a change in the way that gold reacts to the chosen explanatory variables or some new variable has entered the picture. In essence, this is a good example of what happens when in-sample testing confronts out-of-sample reality (the sample used for our model was from January 2007 to April 2020). 

Obvious candidates for how things may have changed are: inflation, central bank purchases and cryptocurrencies. The relationship with inflation is not as straightforward as might be imagined. We use inflation expectations, as measured in the US treasury market (inflation breakevens), but the coefficient in our model is negative, suggesting that gold has tended to fall when inflation expectations rise and vice-versa. We would have expected the opposite. 

Figure 1 suggests that the correlation between gold and inflation expectations is less consistent (positive versus negative) than that between gold and the US dollar. Over the full period shown, the 12-month correlation between gold and inflation expectations has tended to be positive (average of 0.12), whereas for real yields and USD it has averaged -0.14 and -0.47, respectively. However, it had been predominantly negative for inflation in the years before the pandemic, which we had interpreted as a sign that purchases of gold were out of fear of deflation rather than inflation. 

The onset of the pandemic saw a return to a positive correlation with inflation, which may or may not have had fundamental underpinnings: gold may have been rising in reaction to a weakening dollar, rather than as a result of rising inflation expectations. Indeed, a more complex partial correlation analysis that includes inflation expectations, real yields and USD as explanatory variables is less conclusive about the results for inflation expectations at that time. 

Clearer cut is the positive correlation with inflation expectations during 2022, with the partial correlation analysis supporting the evidence in Figure 1. Bearing in mind that US CPI inflation moved from 0.1% in May 2020 to 9.1% in June 2022, investors may have turned to gold as a store of value and this could explain why it outperformed our model. However, it should be noted that the correlation with inflation has recently dipped back into negative territory, as has that with real yields. 

Central banks had an outsized presence in the gold market in 2022, with net purchases of 1136 tonnes, up from 450 tonnes the year before (according to World Gold Council data). To put that into perspective, WGC estimates suggest total supply in 2022 was up 2% at 4755 tonnes (including mine production, net producer hedging and recycled gold).   

Those 2022 central bank (CB) net purchases were a record, with the previous highest in recent years being around 650 tonnes (2018). It is also a far cry from the systematic net sales that occurred throughout the 1990s and up to the Global Financial Crisis. Of note is that emerging market (EM) central banks are the dominant buyers (and have been for some time). 

So, why the surge in CB demand in 2022?  Perhaps it was an attempt by EM central banks to mitigate the effect of inflation upon the value of their reserves (or more simply reflects momentum purchases after sustained gold price gains). As an aside, the Turkish central bank was the largest reported net buyer in 2022 (148 tonnes) and it had an extreme bout of inflation. As global inflation eases, these sorts of precautionary purchases may decline. 

However, there were 741 tonnes of unreported central bank purchases in 2022, which raises the suspicion that Russia was very active. According to Visual Capitalist, it had been the biggest central bank buyer in the 2000-2021 period, accounting for 28% of net purchases, and had more reason than most to diversify its reserves during 2022 (after sanctions imposed when it invaded Ukraine). This may also have been an incentive for China, which bought 62 tonnes in 2022.  Such purchases may ebb and flow with geopolitical tensions but could be an important source of underlying demand as EM countries seek to reduce the influence of the US (“de-dollarisation”). 

Finally, gold may have benefited during 2022 from the collapse of cryptocurrencies, given that both are thought by some to offer mitigation against inflation and financial crises. If that were a factor, it should now be working against gold as cryptocurrencies have enjoyed something of a rebound. 

In conclusion, the surprising strength of gold relative to our model may have been due to a number of factors: the rise in inflation (and a switch to using gold to mitigate against inflation by central banks and others); geopolitical tensions, which may have increased the desire among EM central banks to diversify reserves and, perhaps, the debunking of the idea that cryptocurrencies can act as a store of value. 

However, inflation is now easing, geopolitical tensions ebb and flow and cryptocurrencies have rebounded. Of course, we now have a banking crisis and the debt ceiling to worry about. But gold appears expensive compared to historical norms (see Figure 2)… unless you believe in a return to some form of gold standard – our calculations suggest that gold would need to be valued at $8800 if it were to fully back US currency in circulation (up from the $7000 referred to earlier).

All data as of 12 May 2023, unless stated otherwise.