Persistent inflation and a recent spike in geopolitical risk have driven a surge in the gold price. Gold has advanced approximately 15% since the end of February through mid-April.

Should gold investors pocket recent gains or hang tight?

The move in gold marks a significant breakout from its post-Covid trading range. Gold broke $2,000 per ounce back in August of 2020, following a pandemic-era rally that was fueled by falling interest rates and risk aversion. Since then and through February 2024, the gold price basically fluctuated within a $1,700 to $2,000 band.

At the beginning of March 2024, however, gold prices finally surged through $2,000. This momentum continued into April. Many analysts are now talking about $3,000 as the next stop.

What is driving the recent strength? These things can never be understood with scientific certainty, but we would highlight a couple of key events in March and April.

(1) Dovish Fed meeting

The Fed meeting in mid-March was widely seen as a dovish event. Despite elevated inflation readings in January and February, strong economic growth and low unemployment, the Fed indicated it was still on track for three rate cuts this year. Coupled with comments about a potentially rising “neutral rate,” gold investors perceived an election year stance that was soft on inflation.

(2) Central bank buying

Central banks continue to be net buyers of gold, especially emerging market countries like Turkey, China and India. Central banks have a major influence on gold demand and are believed to own approximately one-fifth of the total supply of gold that has ever been mined.

As a reserve asset, gold is unmatched in its safety, if held in a vault within a country’s own borders. U.S. asset seizures and sanctions against Russia have raised the risk of legal maneuvers or other weaponizations of the banking system that undermine international claims to sovereign bonds. Gold is unique among reserve assets in that it is no other nation’s liability (so long as crypto remains a fringe asset within central banking circles).

On April 4, U.S. Secretary of State Anthony Blinken pronounced that Ukraine will eventually become a NATO member. While this was not the first mention of it, the Biden administration appears to be doubling down on the core diplomatic disagreement that gave rise to the conflict in the first place.

The U.S. and Russia cannot engage militarily, due to the logic of mutually assured destruction. This leaves the global banking system as the most likely theatre for an escalation of the war. Central banks around the world have been taking notice.

On the evening of April 13, Iran launched a surprise missile and drone attack on Israel. While gold has been relatively stable since then, it is conceivable that some of the prior move in gold was driven by governments or other actors who anticipated this unprecedented military maneuver by Tehran.

Will gold rise further?

We like gold and consider it an important part of any well-diversified portfolio. Gold has delivered attractive returns over long periods of time (better than 8% annualized over the past 20 years).

Gold has also exhibited relatively low correlation with stocks. In moments of crisis, like the present, gold is often negatively correlated with stocks. As equity markets have sold-off in recent weeks, gold has once again shown its value as a complement to an equity-tilted portfolio.

Gold still represents the ultimate form of payment in the world. Fiat money, in extremis, is accepted by nobody. Gold is always accepted. - Former Fed Chair Alan Greenspan, speaking to Congress, 1999

With few cost-effective industrial applications, gold is ultimately just a store of value (even when used as jewelry, especially in India and China). Due to physical scarcity and mining complexities, the gold supply tends to grow no faster than 2% per year.

Since gold produces no cash flows, the value of gold is therefore best understood in relative terms. When gold becomes very expensive relative to other asset classes, investors who own gold within a portfolio should take the opportunity to realize gains in their gold investments and rebalance.

For example, in 2011, the gold price (as we now know with the benefit of hindsight) became extremely extended.

The closing price of gold in New York peaked on August 22, 2011 at just under $1,900 per ounce. This was more than three times higher than where gold had closed exactly five years prior. Gold would then lose approximately 40% of its value over the next four years or so, when it bottomed at just under $1,100 per ounce at the end of 2015.  

Despite the recent run-up in gold, we do not believe gold is anywhere close to dangerous relative valuation levels, like what we witnessed in 2011.

In fact, in historical terms, the gold price seems well-supported—if not cheap.

The Federal Reserve defines the “monetary base” as all currency in circulation plus bank reserve assets. It is a commonly used measure of the total quantity of U.S. dollars that have been injected into the economy.

Below, we chart the price of gold relative to the monetary base. When gold ran to $1,900 in 2011, it had significantly outpaced growth in the U.S. money supply.

The relationship between the U.S. monetary base and the gold price is far from perfect and is not the only variable to consider. But at the risk of oversimplification, the more dollars in existence, the more valuable gold should be in dollar terms.

One compelling explanation for the gold price correction after 2011 was that gold investors were too enthusiastic about continued sharp growth in the money supply. The monetary base would soon enter a long period of stabilization.

It was not until the pandemic-era expansion of the monetary base, beginning in 2020, that the gold price finally started moving again. While gold has performed reasonably well over the last five years, this performance is largely in line with U.S. money creation.

Gold is potentially only now catching up with recent money supply growth. Whereas the gold price has increased approximately six-fold over the past 20 years, the U.S. monetary base has increased approximately eight-fold.

The role of interest rates

The very sharp upward move in interest rates over the last several years has had the effect of redirecting demand from gold to bonds. The Fed Funds Rate went from effectively zero to 5.25%-5.50%.

This was a dramatic reversal. When you can suddenly earn much higher risk-free returns in government paper, this draws buying demand away from assets like gold that do not generate cash flow. The likely impact was to suppress upward momentum in the gold price that would have otherwise followed increases in the money supply.

We are now at a moment when markets expect the Fed to start cutting rates. To be fair, we are skeptical that the current “dot plot” prediction of future rate cuts will come to fruition. As the March inflation report that was released on April 10 just indicated, inflation does not seem to be subsiding at hoped for rates.

Short-term interest rates may not get cut as planned, and long-term rates may continue to drift upward in response to persistent inflation. But any upward pressure in rates is unlikely to match the intensity of rate hikes that started in 2022.

When it comes to rates, competition from rising bond yields is subsiding and possibly reversing. On the margin, bonds are becoming less attractive versus gold.

Gold versus other asset classes

Money supply is only one reference point that should be considered when trying to assess the relative price of gold. Gold can also be seen through the lens of other asset classes, such as the stock market.

The price of gold relative to the S&P 500 Index is close to its lowest levels in decades. The ratio is down approximately 70% from the 2011 peak. Again, this is not a perfect mathematical relationship, but another useful indicator of relative value.

The price of gold is difficult, if not impossible, to forecast. But over time, gold moves in relation to the total supply of money and the total nominal value of other asset classes. The current gold price appears to be supported by the upward trajectory of these competing stores of value, which have also benefited from inflation.

Geopolitical risk

The U.S. response to the Ukraine conflict has been a catalyst for a reassessment of the global monetary architecture. It has introduced risks that central bankers around the world will not soon forget.

This calls for a longer discussion, but many believe we are now at the early stages of a “de-dollarization” process—a global phenomenon in which private investors and central banks rotate from U.S. Treasuries to other assets, including gold.

While both the Ukraine/Russia and Israel/Iran conflicts remain unresolved, China has not lost its interest in consolidating Taiwan. We view a move by China to take Taiwan as arguably the biggest geopolitical risk facing markets in the years ahead.

China, like Russia, is a nuclear power. Since direct military confrontation is almost unthinkable, a strong economic response to a possible invasion of Taiwan is more likely. Such a response to a Chinese move on Taiwan would likely inject a degree of turmoil into the global financial system that far surpasses the impacts we have seen thus far this year.

It is hard to imagine an invasion of Taiwan (or even just a heightened perception of the possibility of it happening) not creating demand for gold from all corners of the globe.

Multiple drivers

To sum up, we view the recent move in gold as justified by several factors. Post-pandemic growth in the money supply, nominal wealth creation across other asset classes, moderating or declining interest rates and heightened geopolitical risk all support gold demand.

As we saw in 2011, gold also has a historical tendency to take on momentum and become detached from underlying economic drivers. We do not advocate chasing bubbles—but we also do not object when we own investments that have the potential to get swept up in a wave of positive momentum in the future.

International conflicts are inherently unpredictable. A soothing of tensions may lead to a retreat in the gold price, while an escalation of any of the ongoing conflicts (or the emergence of a new one) could intensify demand.

Even if there is short-time relief, many central banks around the world are likely to continue to prioritize gold reserves over the paper obligations of the U.S. government or other aligned nations. The same goes for private investors.

We continue to recommend a material portfolio allocation to physical gold and other gold-related investments. Gold-related investments remain a core component of our Inflation Protection Model Portfolio.

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