Central bank behavior and gold trading

 

Gold has had a complete turnaround after reaching highs well above $5,000 an ounce. So, what was going on? One clear indicator is that central banks have cut their gold purchases. Central banks have not been viewed as profit maximizers, but the high prices in the first quarter may have been too much, and they took a step back from the market. The other profit-maximizers may have had the same view, and the result has been an over 25% decline from the highs in just over one quarter. This has occurred with both a Middle East war and continued inflation. 

While real-time buying by central banks is hard to obtain, the demand for gold by different agents is still an important way to track gold dynamics.  

Gold overtakes Treasuries as central bank reserves

 

From work done by the ECB, gold has now overtaken US Treasuries as the largest reserve asset for central banks. This is driven by the strong price appreciation of gold over the last year, even with the recent declines. US Treasuries have seen yields rise, reducing the value of the asset. This is not surprising, given the strong buying by central banks, especially over the last four years, amid rising inflation. Still, it suggests that central banks have less confidence in government debt as a safe asset.

Safety is relative, and from the perspective of central banks, it makes sense to hold an asset that is likely to preserve its value during periods of higher inflation. Is the inflation-gold link strong? Not really, but it does seem to be a better inflation hedge than bonds when an inflation shock is expected. Gold can earn some yield if it is leased, but generally there is no yield, whereas bonds may earn a positive real yield.  

Central banks are telling us they lack confidence in their ability to control inflation globally.

Commodites versus stocks - Go with the real economy?

 

The power of supply shocks and the real economy can be seen when we compare the BCOM with the NASDAQ and SPX. Since the beginning of the year, there has been a strong acceleration of commodity prices. This momentum was even before the Iran conflict. A combination of strong demand and a supply shock has been driving the commodity market, even amid all the buzz about AI. Of course, AI is driven by electricity (energy) and infrastructure (metals). 

Commodity shocks and financial markets

 

The first quarter is a commodity shock quarter. We had the gold and silver bubble and it bursting at the end of Jnauary. That seems like ancient history versus all the uncertainty from the war in Iran. The broad market is off more than 5%, yet the energy sector is up over 35%. More importantly, the price of oil is up over 50%, and gasoline futures are growing by 60%. There is a clear link between oil price shocks and financial markets. It is a one-two punch to equity and bond markets, and we have strong evidence of its effect across decades, dating back to the shocks of the early 1970s. Most of these large shocks are self-induced through violence. 

Beyond the magnitude of the shock, the key issue is the time required to return to normality. Short-term shocks can have a strong impact on short-term returns but then reverse quickly. The longer the shock lasts, the more likely it is to have a real effect on growth and inflation. The effect on growth is simple. An increase in energy prices is a tax on consumers and production. However, the US economy is less oil-price-sensitive than it was in the 1970’s, so it is hard to use this period as a control or base case. For inflation, the impact is closely tied to the actions of the central bank. An oil price shock is a relative price change, not an increase in the general price level; however, if the Fed lowers interest rates to support the economy, this price change can trigger an inflation surge.

All eyes are on whether this conflict will be prolonged, and with each day it continues, this short-term shock will be revised into a larger, economy-wide recession-inducing crisis. For many in the emerging markets, energy shortages are real and already disrupting growth.

Price action by Rhetoric: Trump and Oil

 

The FT chart provides an interesting insight into the drivers of the current oil market. Of course, oil is driven by the events of the Iran War, yet the impact on oil prices is more subtle. There seems to be a direct connection between President Trump's comments and the surge or decline in oil prices.  When Trump makes comments that escalate tensions, usually before or on a weekend, there is a surge in prices, followed by comments that de-escalate tensions. The uncertainty in prices is associated with rhetoric rather than specific action surrounding Iran. The sample is small yet there may be a link between comments and oil price action. 

Gold central bank holdings - Saying no to fiat money

The perception of the gold market has changed radically since the Great Financial Crisis (GFC). During the first 10 years of the century, central banks sold gold. Who wants gold when you can have dollars, euros, or yen? Who wants a real asset with no yield when you can have a financial asset with a yield? Who wants a real asset when inflation was under control and less than 2%?  

Now, we know who wants these assets - central banks. These institutions create fiat money, and they don't want it from their peers. Of course, rates were set to zero and, in many cases, moved to negative values during the period of QE. If financial assets can yield negative returns, a hard asset with zero yield looks pretty good. If government debt reaches a new high well beyond GDP, we can suspect it will not be paid with taxes, and governments will have to default on the debt or inflate their economies. The pandemic suggested that governments will go to any lengths to boost the economy with new money. 

The central banks are acting rationally and not telling the public what they really think. Fiat money is out, and hard assets are in. 

A link between policy uncertainty and gold

 

"A bet on gold is really a bet that the people in charge don't know what they're doing."

- Matt O'Brien, 2015

'The monetary order is breaking down,' - Ray Dalio

Gold prices have reached uncharted territory amid US policy uncertainty and trade tensions. You could look at headlines and make some connections, but more importantly, we can examine objective measures of uncertainty as indicators of a change in the monetary order.

The trade policy uncertainty index has fallen from high levels, but remains at extreme levels. The global economic uncertainty is also high and at extremes. 

If the monetary order and policy framework is breaking down, there will be a search for safety. However, if the safety of holding dollars and Treasuries is no longer present, we will see a search for alternatives, and right now that is in precious metals. 

Gold allocations will rise, and even a small increase across many portfolios will create demand that current mining production cannot meet. This is fueled by increased demand from central banks. 

What does gold arbitrage tell us about globalization

 

Gold quality is the same worldwide. There are differences in purity which can be accounted for in price, but an oz of gold in Shanghai, London, or New York should fetch the same price within a range. The price range difference should reflect the cost of transporting physical gold from one location to another. The tightness of price differences around the world is a measure of the fissure of globalization and free trade. If the world is in a free trade environment, gold price differences should be within the range of transport costs. If there are large differences in locational prices, trade is disrupted. 

A close look at price differences across major gold markets suggests an arbitrage breakdown due to tariff uncertainty in 2025. There has also been a disconnect in physical markets due to the desire of major buyers to hold gold in their own domiciles. As gold has become in short supply in some locations, there has been a disconnect that cannot be solved by the usual form of transportation arbitrage. This is a sign of a bubble, but also a sign that investors and physical users do not want to have geographical uncertainty.

Supply - demand imbalance and commodities

 

Commodities have price cycles between supply and demand imbalances. Sometimes the imbalance is caused by a supply shock, such as a war or a weather event. Sometimes it is a demand shock caused by unexpected growth in a specific market sector. 

Beyond the shocks, there are natural imbalances that arise when demand increases, yet there has been underinvestment in supply, or supply production is too slow to address the immediate demand. This is likely to occur in metals markets, which need a long lead time to mine and process ore.

Mining is capital-intensive, and if the return from mining is uncertain or too low relative to other investments, capital will move to other sectors, leading to a supply shortfall. 

The supply and demand imbalance in metals is especially problematic because demand increases are hard to respond to when supply production has a long lead time. This issue gets worse when there are supply chain shocks. Mining supply change shocks occur when one supplier drives price, and there are limited alternatives for finding new supply. 

The current supply-demand imbalance is not just a gold problem, but a silver problem. In fact, there is a supply imbalance with nickel, cobalt, copper, palladium, rhodium, and aluminium, along with a rare earths supply change problem. Surprisingly, all of these imbalances have been documented yet are only now being recognized. 

Commodities diversification more than just gold

The talk of the commodities markets has been gold and silver, yet this asset class is much larger and still offers investors diversification opportunities. Diversification is more than just correlation - it requires respect for returns. However, investors should not forget that many commodities and sub-commodity groups can provide diversification for the same reasons as gold. Real assets are effective hedges when inflation is still above central bank targets. There will be cycles, but at high gold price levels, other real assets become more attractive.

The hard money perspective - not a valuation tool

 

I have seen these charts, and they do not say that gold is cheap, nor do they say that gold should go higher. It does tell us that the dollar, as a fiat currency, debases our purchasing power. 

In a bubble, one of the greatest problems is determining value. Those who want ot see gold higher will trot out valuation metrics that say it should go higher. Those who think it is overvalued will bring out other valuation metrics. Who is right? It is not clear until time passes which one had the better metric, and even then, an investor could be right for the wrong reasons. All of these metrics are relative, and there is nothing to say that there should be mean reversion. 

Gold is cheap, or stocks are overvalued. Take your pick.

Let's make the gold story simple - High uncertainty

We can make the gold story simple; there is high uncertainty. The world policy uncertainty is at extremes. The world uncertainty index is at extremes. The world trade uncertainty is at extremes. If there were a bubble measure of uncertainty, we would be in that bubble. The exponential growth is clear.

If you had a choice of assets, the safe asset associated with government debt that may be affected by world policy, and trade uncertainty, or a hard asset that should have an independent or intrinsic value that is not related to debt policy, overall uncertainty, and trade, you will likely choose the hard asset. While debt continues to grow, the supply of gold can only increase through more mining, which takes time to expand. 

An inelastic supply in the face of a strong demand shock will lead to higher prices. Cut the uncertainty, and gold demand will decline. However, uncertainty requires policy clarity, which is in short supply. 

 

Gold not following fundamental model

 

The chart above is the gold attribution model for UBS. Their chief strategist notes that the residuals have gotten larger since the Ukraine-Russia War. The argument is that the buying of gold has not followed the classic link between the dollar, real rates, and uncertainty. The residuals have gotten larger and have been on one side. The residuals indicate that gold is being driven by other factors, and the link to fundamentals has weakened. If we do not have a strong reason for the delinking, then there is reason to believe that gold will mean-revert.

Central banks like gold more than Treasuries

 

This is one of the most interesting charts this month. Central banks have kept more gold than Treasuries for an extended period until about 1997, when there was a switch to holding more Treasuries. This was the period of Bretton Woods II, when central banks increased their reserves as a measure to help defend their currencies in a crisis. Now, these central banks prefer gold over the safe asset of Treasury securities. There is a fundamental change in the perception or common knowledge concerning Treasuries as a safe asset.

Gold and the problem of fiat money

 

The US government has consistently tried to marginalize gold, and has all of the focus on the dollar, but that only works if we behave ourselves. If we add a lot of debt on top of a fiat currency, it doesn't work.” - Chris Walen

I have not been a gold bug, nor will I change, but there is a problem with fiat money. Money is a store of vlaue because people believe it is a store of value. It is a matter of trust. The safe asset is a safe asset becasue it is belived to be a place where value is maintained.

The literature on safe assets does note that the safety is a relative concept. If there is too much of the safe asset, there will be a decline in that asset's safety value. When that happens, investors will look for other safe assets. If those other safe assets have a problem of excess supply, there will be a demand for real assets that offer safety and limited supply. 

The increase in gold demand is a response to the excess supply of Treasuries based on the large US budget deficits. The safety of Treasuries is being eroded, so there is a search for alternatives.  

Commodities march differently than gold

Gold is going higher, so it must be the case that commodities are also going higher? The data tells us otherwise. Commodities, on average, have been rangebound, but the gold versus commodity ratio tells a different story. The gains in gold are the result of something different. It is driven by the demand for a safe asset, not for its use in some production process or for consumption.  

Does this mean that commodity prices should see a gain in the future? There could be a general commodity rise, but it is not in the card based on a ratio. Sometimes a charge is interesting but not informative.

 

Gold as a safe asset - an alternative to debt.

 

One of the topics that has received attention in microfinance research is the discussion of what constitutes a safe asset and whether it is in short supply. 

During a crisis, there is an increased demand for safe assets that are information-insensitive and serve as a means to protect wealth. A simple example of a safe asset is the US Treasury bill. When there is high uncertainty, investors tend to sell risky assets and shift to safer ones. However, if there is a shortage of these safe assets, the price will be bid up, placing downward pressure on interest rates. 

Nevertheless, there is the assumption that the supposed safe asset will really be safe. That is, the risk or market uncertainty cannot come from the producer of the safe asset. If there is an increase in risk from the safe asset, it will lose its convenience yield, and it will no longer be uncorrelated with risky assets. 

In this case, there will be a demand for alternative safe assets. One alternative is gold. Gold is often uncorrelated with risky assets during times of stress. It is negatively correlated with volatility and uncertainty, and it often protects against higher inflation that impacts the real value of debt-safe assets. It is information-insensitive, and it can be used as collateral. 

Many have suggested that gold is in a bubble, but that narrative shifts if you view gold as a safe asset substitute. If the US debt is less secure, then there will be a stronger demand for gold, which will push its value higher. If the relative safety shifts to gold and away from debt, then there will be stronger upward pressure on gold. The price increase has been significant, but it will be sustained if the safety feature continues to drive demand.

Gold and central banks - Do what we do not what we say

 

I thought at one time that central banks believed that gold was a "barbarous relic". Those times are long gone. The latest survey on central bank behavior and gold shows that 3/4ths will increase their gold portion of total reserves. It is higher simply because the price of gold is higher; yet, we are seeing more central banks increasing their gold exposure. Where is it coming from? Survey results suggest that dollar exposure is expected to decline. Reduce dollar exposure and hold more gold. 

43% of central banks expect to increase their gold exposure in the next 12 months. This is up from 8% in 2019. Gold, the hard asset, is back with central banks. No, this comes even as inflation has fallen, so central banks may be arriving late to the table, although central bank gold holdings have been on the rise for years. 

The explosive increase in gold prices is simply. There is a shortage of this "safe asset" relative to supply. There have been pockets of lower demand, but central banks are price-insensitive 800-lb gorillas in the gold marketplace. This is more than an inflation hedge, but for many EM central banks, a sanction hedge. 

It is hard to see a substantial price reversal in gold when central banks are key buyers. Gold is not at attractive prices for accumulation but central banks are telling the market you should hold this diversifier. 

Gold price increases tied to higher uncertainty

Gold is considered a safe asset because it has the safe asset statistical qualities of being negatively correlated with risk assets during a market downturn. While this is generally true, it is not always the case. We know that gold has some of the characteristics of a safe asset because it will do better when there is high uncertainty. A simple examination tested more formally in academic research finds a positive link between gold, volatility, and uncertainty. From volatility, there is a change in asset demand. More risk with risky assets will lead to higher demand for safe assets.

Cropland decline - A future concern

 

US cropland has declined over the last ten years. It was steady from 1998 to 2014, but the farmland acreage is decreasing. See the farmdoc daily blog for the details. What is especially scary is that the economists who have looked at the data do not have a good explanation for this fall. We should be especially concerned because if there are no increases in productivity, we will be in a food deficit. Of course, Latin America has been a large marginal producer, and there is no current problem, but the risk of a food shortfall will increase if there is less land for farming. This is an issue worth keeping on the radar screen.