ENG Market Strategy

Market focus: Deciphering the gold puzzle

Most of the conventional theses developed over the last fifty years failed to provide a satisfying framework to explain the dynamics of gold prices. Gold looks increasingly like an asset that is exposed to a complex set of systematic and idiosyncratic risk drivers. It is important to acknowledge all these factors before rushing to conclusions.

Quid non mortalia pectora cogis, auri sacra fames ?  (To what lengths will man’s passion for gold not lead him?)

Virgil, Aeneid, 3.56-57.

The famous passage quoted from Virgil’s classical epic poem, the Aeneid, tells how Polymestor, king of Thrace, betraying the thrust of his friend, Priam, murdered Priam’s younger son, Polydor, in order to seize the gold brought with the boy from Troy for safekeeping. The mythological story of King Midas, who transformed in gold everything he touched, is another reminder that gold is a blessing that might turn into a curse. As scholar J.W. Graham reported, “the imperishability of gold combined with its high value in concentrated form, has always provided a convenient way of storing and transmitting wealth”. In Athens, a sculpture of Athena Parthenos, the goddess protecting the city, was decorated with over a ton of pure gold, worth more than $50 million in today’s prices. According to the Greek Historian Thucydides, the gold could be smelted and used as a final resort in time of state emergency, but it had to be restored in full as soon as possible.

Fast forward to the XXIst century and it seems that the fascination for gold as a store of value, both in good times and in bad times, is as important today as it was 25 centuries ago. Two world wars, the collapse of the British colonial empire and the Vietnam war led to the abandon of the gold standard and of its post-1945 ersatz, the gold exchange standard. Yet the “barbarous relic” – as John Meynard Keynes once famously called the gold standard and by extension gold itself – is once again attracting professional and retail investors. The ever growing open interest in gold futures – that routinely stands between $100 and $150 billion -, and the increasing volumes of “mum and dad” money invested in gold-backed ETFs – to the tune of $200 billion – are a testimony of new gold frenzy. In the 2Ks, the price of gold rose sevenfold before losing almost 40% of its value in dollar terms between 2012 and 2016 and hovering on a plateau before starting a new rally in 2018.

It should be recalled that interest for gold had similarly surged in the 1970s, following the demise of the post-war gold-exchange standar,,d starting with the Nixon shock in 1971. At that time, in a stark inflationary environment, fuelled by two major oil shocks in 1973-1974 and in 1979, the price of the yellow metal jumped more than twenty times between 1971 and 1980, from its long standing official level of $35 an ounce. From that period of stagflation, which was in a way reminiscent of the major German hyperinflation that followed World War I, gold inherited a reputation as a hedge against inflation … or rather hyper-inflation. Or was it actually perceived as a hedge against macroeconomic uncertainty? The answer is not that clear. Actually, gold performed poorly on a long term basis as a hedge against inflation. Adjusted for the prices of goods ans services, the value of gold fluctuated wildly over the last fifty years.

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Another widely held belief among investors is that gold may act as a hedge against excessive monetary supply – which makes it the investment of choice in an era of seemingly unlimited “Helicopter money“. However, as can be seen from the chart below, the relationship between the price of gold and money supply – or more precisely of excess money supply, as measured by the excess reserves of depository institutions held at the Federal Reserve – is quite loose. As a matter of fact, the gold rally that started in the early 2Ks might have been supported by the first waves of Quantitative Easing initiated by the FED starting from 2008. However, the price of gold did not react very well to the QE3 initiated in 2013. In fact, the massive increase in the FED’s balance sheet that brought its total assets to more than $2.5 trillion in 2014 coincided with a sharp sell-off of the precious metal, while the tapering of QE initiated by the FED in 2014 coincided with a stabilisation of the price of gold followed by a new rally.

It seems difficult to relate the price of gold to any macroeconomic fundamentals, at least if we are talking about central projection tendencies and realised values. An alternative might be to look at the second and third moments of key macroeconomic and financial variables. This has been intuitively perceived by gold investors and holders for thousands of years. According to this intuition, gold is the ultimate store of value, especially in times of uncertainty, as it is not possible to manipulate its value, as opposed to fiat currencies, especially since the relationship between a country’s gold reserves and the value of its currency has all but disappeared following the collapse of the Bretton Woods system.

The analysis of the correlation between the price of gold, the volatility of the equity market – the VIX index – and long term interest rates – the yield on US 10 years Treasury bonds- can help us assess the soundness of the aforementioned intuitions. The correlation of daily returns between gold and the VIX index has been unstable over the last twenty years. Periods of mostly negative correlation were followed by periods of mostly positive correlation without there being any obvious statistical relationship between the price of gold and the indicator known by markets participants and analysts as the “fear index”. The price of gold has been mostly negatively correlated with the variation of long term interest rates. This means that gold prices tended to move in tandem with bond prices, in an environment in which the later tended to appreciate, as a result of a persistently loose monetary policy, reflecting its defensive status. However, there have been also many episodes as of late in which gold moved alongside equities, especially during periods of heightened macroeconomic uncertainty.

In conclusion, most of the conventional views developed over the last fifty years failed to provide a satisfying framework to explain the dynamics of gold prices. Gold looks increasingly like an asset that is exposed to a complex set of systematic and idiosyncratic risk drivers. It is important to acknowledge all these factors, contribution to gold’s returns tend to vary through time – which make it a good candidate for portfolio diversification and risk/return optimisation. We will test and refine these ideas in future posts.


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