After rising about 40% since last October, it is on a major rally. Many investment experts consider gold prices to be a macro barometer that measures the level of anxiety in the economy, inflation, currency and geopolitics. Therefore, we must investigate what causes it to rise and what does not cause it to rise.
Divorce between gold and real returns
To help us figure out what might be driving the momentum in gold, it’s worth first considering that the reliable relationship that largely explains gold price movement broke down about two years ago.
The chart below, courtesy of Matt Wheeler, shows that the 15-year relationship between gold prices and real yields no longer works. Real yields or real rates are simply the current yield on Treasury securities minus the inflation rate or expected inflation.
It serves as a measure of how loose or restrictive monetary policy is. The higher the real yield, the more restrictive monetary policy will be, and vice versa.
The chart below shows the current level of real yield, which is the highest in fifteen years. Accordingly, it is fair to claim that monetary policy is too restrictive, regardless of how the Fed has changed its stance in recent months.
In our article, we discussed why there is a relationship between gold and real returns.
The level of real interest rates is a strong measure of the Fed’s policy weight. If the Fed is treading lightly and not distorting markets, real rates should be positive. The more the Fed manipulates markets beyond their natural rates, the more negative real rates become.
The article shared our analysis that divided the past 40 years into three periods based on the level of real returns.
When Federal Reserve monetary policy became more aggressive in 2008, the relationship between gold and real yields grew. Before 2008, there was no statistical relationship.
According to the article:
The first graph, the pre-QE period, covers the period 1982-2007. During this period, real returns averaged +3.73%. An R-squared of .0093 shows no relationship.
The second chart covers quantitative easing associated with the financial crisis, 2008-2017. During this period, real returns averaged +0.77%. The R-squared of .3174 shows a moderate correlation.
The final chart, The Era of Quantitative Easing II, covers the period after the Fed began reducing its balance sheet and then increasing it sharply in late 2019. During this period, real returns averaged 0.00%, with many instances of negative real returns. The R-squared of .7865 shows a significant correlation.
Given our historical analysis and the current state of high real returns, it is not surprising that the relationship between the gold price and real returns has vanished.
So, without real yields controlling the price of gold, let’s look at some possibilities as to why it has risen so quickly.
Financial imbalance
The federal government runs a large deficit. As shown below, the annual percentage increase in the federal debt is more than 8%. Such significant deficit spending is occurring at a time when economic growth is exceeding the natural growth rate and pre-pandemic levels. Deficits are typically smaller during periods of economic growth and larger during recessions or economic slowdowns.
The recent increase in debt growth is significant, but not much more than other non-recession peaks in the past 10 years. Additionally, they are much lower than the increases in debt associated with recessions. A deficit of more than 2 trillion sounds scary, but the economy has grown 33%, or $7 trillion, since 2020 and has doubled in size since 2009. The chart below, which shows the debt-to-GDP ratio, helps put more context around the Government borrowing.
The upward trend in the debt-to-GDP ratio is unsustainable. However, the current ratio and slope of the recent trend are in line with the trend of 20 years ago and even more so.
We have written many articles about the problem of debt growing faster than GDP and the economic damage it is doing and will do. However, when the current deficit is put into context with the pace of economic activity, recent growth is not starkly different from other experiences in the past 20 years.
As such, we find it difficult to believe that debt is responsible for the recent rise in gold.
Geopolitical
The geopolitical problems, especially regarding Ukraine and Israel, are indeed problematic.
Russia could deploy nuclear weapons or expand the scope of the war to other neighboring countries. Invading a NATO country would force the United States and European powers to intervene.
The conflict between Hamas and Hamas appears to be a proxy war with Iran. While the theater of war is primarily in Gaza, and to a lesser extent in the surrounding countries, the possibility of Israel and Iran being directly involved is more problematic. Direct Iranian actions against Israel are likely to be met with military force from the United States and other NATO powers.
I don’t mean to downplay these two and other less important geopolitical events, but the United States and Europe have been fighting various wars in the Middle East and Afghanistan for most of the last 20 years. Is the global geopolitical situation today much more frightening than in years past?
When we began writing this article on April 4, 2023, a rumor was circulating that Iran may be planning missile attacks against Israel. The index fell more than 1% quickly, and gold immediately fell by $25. If geopolitical concerns are responsible for the recent gains, shouldn’t rising tensions in the Middle East increase the value of gold?
Gold predicts inflation, or does it?
Some argue that gold prices herald a reversal of the low inflation trends that have prevailed over the past 30 years.
If gold is such a good indicator of prices, why didn’t its price decline when the Federal Reserve and the government were showering the economy with money and supply lines were closed? This period represented the most significant inflationary setup in more than 40 years.
Dovish Fed in a high inflationary environment
Since late last year, the Fed has shifted from a very hawkish tone to a more dovish one. Despite easy financial conditions (), high and steady inflation, and above-average growth, the Fed appears intent on cutting interest rates several times this year. Many would argue that a more dovish Fed would maintain its hawkish tone and perhaps raise the specter of raising interest rates further.
As we explained earlier, monetary policy, although seemingly becoming easier, remains at its tightest levels in more than 15 years. Compare monetary policy today with what it was in 2013 and 2014. The economy was growing at the time, yet the Federal Reserve was setting interest rates near zero percent and doing quantitative easing. As we will explain below, gold declined during that period, despite the complete neglect of monetary policy.
– Artificial Intelligence obsession
After we’ve discussed some of the standard responses that pundits have regarding gold’s bull run, we’re sharing one that may not be popular with gold holders.
Gold is a speculative asset. Accordingly, it can rise and fall, sometimes violently, based solely on the whims of traders and speculators.
Could the current rally in gold have less to do with the issues we mentioned above and more to do with the speculative mania that is running rampant in many markets? Look at the five charts below. The charts show a clear and statistically strong correlation over the past two years between Gold, Nvidia (NASDAQ:), Meta (NASDAQ:), Eli Lily, and the S&P 500.
summary
The previous few sections share some typical rationales to justify rising gold prices. Although they seem like legitimate reasons for gold to rise, they are not much different when put in context than other periods in the past 20 years when gold was flat or trending down in price.
The price of gold can sometimes provide valuable insights. But other times, gold can give false signals distorted by irrational market behaviors. We believe that gold is in a speculative bubble, and its price does not provide us with a warning of a financial, monetary or geopolitical crisis.
Gold is likely to make a more reliable and sustainable rally when the Fed returns to its careless ways with real yields approaching 0% or even negative, and quantitative easing comes into play again.
2024-04-10 23:15:30
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