Gold is often considered a symbol of greed. But in an illustration of the Seven Deadly Sins, it might fit better under sloth. Much of the world’s gold sits in vaults doing nothing. It can be used in electronics and medicine, but its cost makes industrial applications impractical. It is bought and sold for jewelry, but its price is much higher than it would be if it were only decorative. This makes gold notoriously difficult to value. Most commodity valuation models are based on supply and demand. Investors want to know how much palladium will be used in autos. They look at how much it costs to mine copper or how much corn is being planted. These models can be very sophisticated, but beneath the mathematical complexity, they are based on the idea that price is determined by how much of the commodity is produced and how much is used.
Then there is gold. Gold is not consumed like soybeans or natural gas, and its supply doesn’t change much. The amount of gold mined each year is far less than the amount which sits in the vaults. The stability of supply is part of why it had been used as a currency for thousands of years. While very few people buy their groceries with gold these days, many investors still think of it as a store of value as they have since the time of Croesus. 1 1 Close Croesus was a Lydian king and occasional crossword puzzle answer who pioneered the use of gold as currency. His kingdom became very wealthy but was defeated by Cyrus the Great. According to Herodotus, after Croesus was almost burned at the stake, he and Cyrus became good friends and the Persians used gold in their coins. Some historians doubt Herodotus’ account, but I prefer a happy ending.
For the most part, these investors have been right: over the centuries, gold has been a pretty good store of value. However, its price has been volatile, and there have been periods when gold has lost purchasing power. For a good chunk of the past century, gold prices were fixed in dollar terms, but we do have data since 1971 as to how gold behaves in different economic environments. During this period, gold has done well when other currencies are having problems. At times, it has behaved like an alternative to the current global reserve currency, the U.S. dollar. 2 2 Close At times gold has rallied with emerging market currencies. This may be because EM central banks have more of a preference for holding gold than their developed counterparts do. When their currencies are strong, EM central banks are able to purchase more. The same may apply to consumers of jewelry.
It’s no secret that real interest rates have driven gold prices. Almost every research piece and news article on commodities in the past six months has told you that real rates are a good measure of the opportunity cost of holding gold. 3 3 Close For example, Wall Street Journal: “Gold Will Need More Bad News to Keep Prospering,” 8/15/2020. Real rates measure the difference between nominal rates and inflation. 4 4 Close There are plenty of choices for both rates and inflation, but for this piece we’ll use the Fed target rate and rolling one yearly CPI. Ten-year Treasuries and forecast inflation would be good too. Or PCE deflator. Or an average of global dollar-based rates. Or whatever you want. If the dollar pays high rates over inflation, then it is a very good alternative to gold. If real rates are negative, then the zero you earn on gold doesn’t seem so bad. 5 5 Close Negative if you count storage and insurance.
During the 1970s as inflation rose, the Fed was slow to react, and real rates fell. This was part of the reason gold rallied so much during the period. 6 6 Close It was a bit more complicated. Prior to Nixon’s famous announcement gold prices had been fixed to the dollar. It makes sense that once that was released, gold prices would have some big moves. Since then the Fed has been very responsive to changes in inflation. For much of the 80s and 90s, the Fed kept real rates high to bring down inflation, so gold prices were subdued during that period. During the Financial Crisis, gold initially sold off as investors liquidated whatever they had to meet margin calls. Then the Fed brought rates to zero, and gold went into another bull market, which eventually ended when inflation stayed low and the Fed slowly raised rates.
Now real rates are negative, and gold is rallying. But it is important to understand that the dynamic around real rates is changing, and the way gold reacts to different economic environments may also change. We are at a point where the Fed and other central banks aren’t going to be as reactive. If there is another recession, the Fed is unlikely to cut rates as much as in the past. As a result, a recession would likely bring real rates higher. 7 7 Close If there were a recession, inflation would fall. The Fed would not cut rates much. So we might have -3% inflation and zero rates, which would mean real rates would be at 3%. This is very high and would likely hurt gold prices. As we discussed last time, the Fed is also less likely to react to rising inflation. So what this means is that in the near future, real rates will likely be driven by inflation, not nominal rates or the Fed.
In this environment, gold may be a better inflation hedge than it has been in the past. However, it also means that gold may not perform as well during a downturn. It won’t benefit from fast rate cuts as it has in recent cycles. Some will argue that unorthodox measures from central banks make this an extraordinary time to own gold. These measures may support gold, but the outlook is less clear than the balance sheet enthusiasts would have you believe. Quantitative easing by itself will probably not be enough to support gold – it must be paired with increased spending to have a material effect. It will require coordination between the fiscal and monetary authorities, something we have seen during the COVID crisis. In other words, for the support to continue, they will have to get the helicopters out to drop money on people. As we have seen with the recent debate over the aid package, this coordination should not be taken for granted. Often cooperation breaks down at the most crucial moments.
Gold still has characteristics which make it desirable in a diversified portfolio. It may serve as part of an inflation hedge, and it could very well be the best performing asset if governments adopt Modern Monetary Theory.
Full-fledged MMT would mean that the only limit on government and central bank coordination would be a limit on the number of helicopters to drop the money.
Because real rates are already so low, it could continue its rally if the economy meanders through its recovery. But it will not do well in all scenarios as some folks would have you believe. It is more vulnerable to a downturn than it has been in recent cycles. It could also suffer if the economy becomes so strong that the Fed decides to change its course and starts hiking aggressively.
Doesn’t seem likely, but you never know …
One thing to remember about gold is that because there are no direct supply and demand fundamentals, it is heavily driven by sentiment. There are times when people get very excited about shiny metals and times when they don’t. This makes gold’s portfolio benefits more difficult to evaluate.
All markets are dependent on psychology and sentiment, it’s just that there is less of an anchor for gold. It is one of the most sentiment-driven markets.
Most investors don’t need to hedge against idiosyncratic investor psychology risk. If they did, gold would command an even larger premium than it does now.
What We Are Watching
Germany IFO (Tuesday)
The German Ifo business climate index has been on a rebound trajectory over the past three months and economists are forecasting continued improvement in next week’s release. Gains have come on the back of larger-than-expected improvements in the forward-looking expectations component, which currently stands above its pre-COVID-crisis level. From a sectoral perspective, the largest improvements are taking place in manufacturing, in line with the industrial and export-oriented tilt of the German economy. Another positive data point on Tuesday would help cement further the idea that the European economy is going through a firm cyclical recovery, despite a recent spikes in COVID cases. Such an outcome may support the euro and European stocks, and could weigh on German bonds.
Federal Reserve Economic Policy Symposium (Thursday-Friday)
The Federal Reserve Bank of Kansas City’s annual symposium brings together academics and policymakers from around the world to share new research and discuss topics related to monetary policy and the economy. 11 11 Close Most commonly referred to as “Jackson Hole” based on its usual location in Wyoming, although this year the conference will be held virtually. At times, central bankers have used the conference to describe important changes in thinking or signal the use of new policy tools. This year’s symposium arrives at a time of elevated uncertainty over the global economic outlook and the future course of monetary policy, as central banks have largely exhausted their traditional tools for stimulating growth. While the full agenda has not been published as of this writing, some items have been announced, including speeches from Bank of England Governor Andrew Bailey and Bank of Canada Governor Tiff Macklem. Both Bailey and Macklem have drawn attention in recent months with ambiguous (or misinterpreted) comments on the prospects for negative interest rates in their respective countries, so market participants will be watching both speeches for any changes in guidance. In addition, the Fed has been conducting a comprehensive review of its monetary policy strategy over the last two years, with the potential for important changes to how the bank interprets and pursues its price stability objective. Speeches connected to this review could provide important hints on any eventual changes in strategy, such as adoption of “average inflation rate targeting,” in which policymakers would seek to make up for periods of below-target inflation with offsetting periods of above-target inflation.
Eurozone Economic Confidence (Friday)
The improvement in Euro Area consumer confidence unexpectedly paused in July. A resurgence in COVID cases in some countries and associated quarantine measures such as UK restrictions on travelers from Spain may have weighed on sentiment. With consumption data coming roughly in line with expectations in August, and mixed signals in EU-wide business sentiment surveys, it’s hard to predict which way consumer sentiment will move this month and, with it, the composite economic confidence indicator. Expectations point to a modest improvement, but still reflecti a much more dim level of sentiment than before COVID hit the Euro Area.