After a stellar performance over the past few months gold has found its way back into the headlines, with market prices rising above $2000 an ounce for the first time in August. Having increased some 50% in value since the beginning of 2019, the precious metal that was once synonymous with money is piquing the interest of a growing number of investors, particularly after the recent revelation that longtime gold-critic Warren Buffet had joined in on the gold rally by purchasing shares in a gold mining company.
Buffet had famously once said that gold “doesn’t do anything but sit there and look at you”, alluding to the fact that the metal yields no return as opposed to the companies Buffet typically invests in, or even compared to the safer alternative of government bonds. Yet, as investors like Buffet are coming to realise, decent returns on financial investments are becoming a rarity in this age of historically low interest rates. Adding to this the increasingly routine talk of asset bubbles on Wall Street, the case for buying gold now looks stronger than ever.
The 1971-1980 gold rally
Unfortunately for investors in gold, there is no single reason for its value to rise over time; no one chart to show a constant relationship between gold and some other indicator, making it rather difficult to predict its price at any point in time. While in the past its functions have ranged from being a material for jewelry to being money in itself, since the birth of fiat money gold’s primary function has been to act as a store of value. For those wanting to preserve their buying power as prices of goods rise and the value of their money falls, investing that money in gold has usually been a good bet.
This was perhaps most prevalent when the US and most other countries moved off the gold standard in 1971 and gold, after having its price fixed for more than 30 years, was finally free to catch up to prices of other commodities which had been rising substantially over that period. By the end of the 1970s the price of gold had risen by more than 17 times in Dollars terms. But as consumer price inflation started falling after 1980 and interest in gold died down the rally came to an end, until it reemerged around the turn of the millennium.
The 2001-2011 gold rally
From 2000 to 2011 gold prices rose by 550%. The emergence of aggressive easy monetary policy is often cited as a possible cause for the rise (as it is again today), due to the lower interest rates on government bonds, which make bonds less attractive and consequentially gold more attractive. While this certainly contributed to the gold rally there is one factor which is often understated in its impact on gold prices since 2000, as it is in its impact on the global economy and global financial markets as a whole.
After joining the WTO in 2001 the Chinese economy started to take off in a big way. The impact on the global economy was massive and commodity prices, which had been dormant for several decades, suddenly exploded upwards as production in China sent the demand for commodities through the roof.
Yet, there is another link between the rise of china and the rise in gold prices from 2000 onward that might have had an even larger impact. Over the last two decades China’s 1.3 billion inhabitants (now 18% of the global population) have seen their wealth rise rapidly. From a non-existent middle-class in 1995, 80 million Chinese were considered middle-class in 2005 and acquired the ability to start purchasing significant amounts of assets. It is safe to say gold was a favorite among these, particularly given the fact that financial assets were still difficult to purchase for the ordinary person. As the Chinese middle class continued to grow the global demand for gold kept on being fueled, sending gold prices to a record high of $1900 in September 2011. The correction that followed would leave gold prices to take almost nine years to return to record highs.
Back to the present –why is gold attractive once again?
Although the Chinese middle class kept growing after 2011, gold prices did not. The rallies in primary commodity prices and consumer prices inflation came to an end and fell to new lows by 2015. In spite of the large number of bullish investors who were expecting hyperinflation to follow the printing sprees initiated by the major central banks in the world, gold prices nearly halved from 2011 to 2015, falling from their peak of $1875 to a low of $1160 an ounce.
Since then, however, gold started edging up again, and finally broke out in 2019 to rise to a record high in 2020. Why? Many analysts are now focused on the relationship between gold prices and the real 10-year US Treasury yield, or the nominal yield minus the inflation rate, which has fallen dramatically with the Fed’s introduction of QE unlimited. But I would argue that there are at least three major reasons for the most recent bull-run in gold prices, and although the phenomenon of low interest rates is one of them, plotting the price of gold against real interest rates is perhaps somewhat misleading.
Not real but nominal interest rates
First, it should be considered that rich individuals, who account for most of the trading in financial assets, spend a relatively small portion of their wealth on consumer goods, making consumer price inflation largely irrelevant when considering their returns on investments. For example, if you invest $10 million in government bonds and receive a 2% annual return, or $200,000, are you really going to be worried about the prices of the apples you buy rising by 2%, or even 5%?
The second and more important point about interest rates on investments like government bonds, savings deposits, and money market funds, is that they are alternatives for all other investments, which all exist in a world with inflation. For example, the lowering of nominal bond yields and nominal savings deposit rates has allowed for lower nominal dividend yields on equities. In other words, prices of equities have been allowed to rise without underlying profits and dividends growing to warrant the more expensive equities, because the safer alternatives have lower yields of return too.
While gold offers no return at all it is still a relatively safe asset compared to equities, and it becomes all the more attractive when the alternatives that are also considered safe yield no return at all. In Japan and Europe, rates on government bonds and savings deposits have been zero or negative for close to a decade. As the US has more recently joined this trend the safe alternatives to gold have almost completely disappeared. This fall of nominal interest rates to zero and below, which has never happened before in modern capitalism, is putting an unprecedented upward pressure on the price of gold. Naturally this also makes cash more attractive, which leads to the second reason for rising gold prices: the possible fall of the US Dollar.
Hedging against a Dollar losing its value
The second major reason for the rising appreciation of gold is its function as a hedge against a very likely substantial fall in the value of the US Dollar. The Greenback’s hegemony as world money is becoming increasingly doubtful with the ongoing deterioration of US production, and making matters worse is the fact that the US Federal Reserve appears to have lost all monetary discipline when it comes to printing money, sending more and more Dollars into the global economy without the American goods to back them. What has held the Dollar’s value up in recent years was only the incredible carry trade available for those able to borrow in Europe or Japan at 0% and lend in the US at 2-3%. With the recent fall of US interest rates, however, the carry trade is coming to an end, removing the temporary alleviation of the Greenback’s value.
The long cycle and the inevitable rise in inflation (and interest rates)
A final reason for the upward pressure on gold is one that stems from a longer-term view of the global economy. Today, we find ourselves at the bottom of the long cycle when economies typically experience low inflation. This all changes when the upswing of the long cycle is initiated and fiscal-stimulus induced aggregate demand regains its upward stride. Indeed, the last long-cycle upswing that occurred during 1960s and 70s saw inflation in the US rise from around 1% to a high of 15%. Such a rise in inflation in the coming years would put tremendous upward pressure on interest rates, especially on the artificially low interest rates in the advanced countries that must rebalance at some point in time (assuming there will be something resembling a capitalist system). Although rising interest rates will eventually make bonds more attractive again, nobody wants to hold bonds in the process of rising rates and falling bond prices, making gold the attractive alternative (with the exception of inflation-indexed government bonds).
As was alluded to above, the long-cycle bottom can also see the transition of global power from one economy to another, as we saw with the UK and US in the 1950s, and we currently see with the US and China. The ongoing transition is causing a growing amount of uncertainty regarding the Dollar’s reserve currency status as is visible from the record purchases of gold by central banks in 2019. There is no doubt that these banks are preparing for the inevitable reshuffling of the global financial system, with a new world money at its core. While it is not yet clear which currency will replace the Dollar the transition from one world money to another is hardly ever smooth. During the process, gold becomes a good option for those looking for some safety.