Golden times: What is driving the rally?

The price of gold has risen significantly in US dollar terms, and often even more in other currencies. From mid-2022 onwards, many investors were surprised that the price of gold moved up while US real rates also increased. Historically, gold performed well when US real rates (nominal rates minus inflation) fell, and vice versa. So, why has the correlation between gold and US real rates changed? Why has gold performed so well when real yields rose?

When Russia invaded Ukraine, Western countries and, especially the US, weaponised their currency, mainly the US dollar. Russia’s US Treasuries were frozen, and the proceeds (coupons) are being used to support Ukraine. This action has frightened other countries that don’t see eye to eye with the US. Countries like China have questioned why their central bank should hold US Treasuries as a reserve on their balance sheet when access to these assets could be jeopardised. Consequently, the most logical alternative asset to replace US Treasuries has been gold.

Many emerging market countries have been hoarding gold, literally buying the physical asset and storing it in vaults, preferably within their own borders. Thus, to a large extent, the rise in the price of gold has been a matter of supply and demand, with demand being quite substantial, even when China indicated that it had stopped buying gold over the last two months. Other countries like India, Uzbekistan, Uganda, Czechia, and many more are eager to add the shiny metal to their reserves. It can be said that physical gold is moving from West to East, as Western investors have not really participating in the gold rally (yet).

The price of gold also received a boost when US inflation figures were softer than expected in June. This development enhances the likelihood that the Federal Reserve (Fed) will reduce the policy rate, as has already been the case with the ECB, SNB, and many other central banks. Gold typically performs well when a series of rate cuts begins. However, it is still too early to say that the Fed is on a determined path of many rate cuts. Currently, the market anticipates three Fed cuts by the end of January 2025.

Another element that might play a role is debt sustainability at the government level. In the aftermath of the Great Financial Crisis of 2008-2009 and the COVID pandemic in 2020, governments in both the West and East have spent (invested) enormous amounts to keep the economy afloat, leading to a steep rise in debt-to-GDP levels. This ratio is less important when interest rates are close to zero but become material when interest rates are high. Given the challenges ahead, including demography, defence spending, climate transition, and infrastructure upgrades, government finances worry some investors. This concern also plays into the hands of gold.

A final element concerns portfolio construction. When the economy is in a disinflationary state, the best diversifier for equity risk is longer-term government bonds. In the case of higher inflation, real assets like gold tend to provide better diversification. The jury is still out on the direction but for now, considering all elements mentioned, we maintain a favourable view on the price of gold. Ideally, positions are held in instruments like ETCs that effectively hold the physical gold. Strategically, at least 5% seems appropriate.