By: David Brett, James Luke
For nearly 15 years, the relationship between gold prices and real returns on government bonds remained strong, then something changed. What happened? Listen to the latest Investor Download.
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[00:00:07.930] – David Brett
Welcome to the investor download the podcast about the themes driving markets and the economy now and in the future. I’m your host, David Brett. Usually when interest rates rise and real rates on government bonds turn positive, the gold price tends to fall. But that’s not what’s happened over the past 18 months. Where is the gold price right now?
[00:00:39.860] – James Luke
Well, it’s hovering around us dollar 2000 per ounce which is around and about the all time highs.
[00:00:47.850] – David Brett
That’s James Luke. James is a senior fund manager in Schroders’ emerging market debt and commodities team.
[00:00:55.170] – James Luke
I think what makes it unusual is the fact that gold is at these levels, despite the fact that you’ve seen a very, very significant increase in real interest rates in the US over the last two years. And frankly, the dollar has been pretty strong too.
[00:01:10.660] – David Brett
And when we talk about real rates, we mean the return of a bond minus the rate of inflation, rather than just the yield itself. Gold prices are around record highs, despite this interest rate hiking cycle being the most violent since Paul Volcker vowed to crush inflation in the early 1980s.
[00:01:31.390] – News clip
The way you’re going to get those interest rates down is by persisting in policies that will indeed continue to bring the inflation rate down. At some point, the stam is going to break and the psychology is going to change.
[00:01:44.240] – David Brett
So despite real rates moving very rapidly from negative to positive, over the last. Two years, gold prices have stayed high. But struggled to maintain new record highs. So where should the gold price be?
[00:01:58.950] – James Luke
I mean, if you came into 2022 and you told pretty much any analysts that real interest rates were going to go from negative 100 basis points to positive 200 and the dollar was going to be pretty firm, they would all pretty much have said that gold is going to be somewhere around one $1300 per ounce to 1500, or some $500 plus below where it is today.
[00:02:24.100] – David Brett
At a time when real bond yields across the western world are still high, why is the gold price nearing record highs? We’ll take you through a brief history of the gold price, the geopolitical events that are shaping demand, and why the gold price could remain resilient for some time yet.
[00:02:44.870] – Speaker
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[00:02:51.820] – David Brett
Since 2008, the gold price has tracked the real return on us government bonds. When real returns have risen, the price of gold has fallen, and vice versa.
[00:03:01.830] – James Luke
I think for us, when we look at the history of the gold market, we see 2008 as something of a pivot point. Before 2008, gold really traded more of its commodity characteristics. It traded more in line with jewellery demand, more in line with emerging markets currencies and less in line with real interest rates. I think the real pivot point was post 2008, post the financial crisis. The introduction, as part of a broad policy response of quantitative easing, so called unconventional monetary policy, which in effect just meant printing money to buy more government bonds to suppress interest rates.
[00:03:44.290] – News clip
It was one of the most profound events in generations, with huge consequences for the american economy and households throughout the country. This was the time, a decade ago when the financial crisis erupted, a crash that most experts did not foresee. Its effects, and of the recession that followed on income wealth inequality and our politics are still with us.
[00:04:08.420] – James Luke
And I think from an investor perspective, that raised all sorts of concerns about long run monetary debasement, about long run systemic fragility, and caused a strong underlying bid for gold because of its monetary characteristics.
[00:04:26.860] – David Brett
Are you saying that since 2008, gold prices became much more sensitive to what central banks were trying to achieve?
[00:04:33.900] – James Luke
The way I view it is that the introduction by western central banks, obviously the Japanese central bank, have been doing it really since the mid 1990s. But the introduction by western central banks, led by the Fed, of quantitative easing, of unconventional monetary policy, really marked a watershed moment. And yes, I think that since 2008, it has been the dominant factor driving gold markets at least up until 2022. And I think that when you look at the history of big moves in the gold price since 2008, that’s really very, very clear. So, for example, the big down move that we saw in 2013, 2014, when gold prices fell over a three month period, some $500 per ounce, was very, very clearly linked to the Fed’s attempts in 2013 to normalise monetary policy, to stop doing quantitative easing, to start doing quantitative tightening, or at least the communication that they would do that in the future, that alone was enough to cause very significant selling in the gold market, particularly from western investors. And similarly, when you look on the flip side, the points at which the Fed has been unable to continue normalising monetary policy have really marked the starting point of big up news. So, for example, late 2018, when the Fed, or Powell himself, was forced to capitulate on tightening monetary policy, and then again in late 2019, the so called repo crisis. And as we all know, the post COVID policy response, which really, again, was a new watershed in extreme policy responses, combining both extreme unconventional monetary policy with direct fiscal stimulus, direct fiscal injections into the US economy.
[00:06:23.090] – David Brett
However, that relationship, which had been so dominant for much of the last 15 years, broke down at the beginning of 2022. That’s coming up in the next part of the show.
[00:06:33.700] – Disclaimer
Get in touch with us by email at [email protected]. Or visit our website, www.schroders.comThe-investor-download-podcast/
[00:06:44.630] – David Brett
For nearly 15 years, the relationship between gold and real returns on bonds was strong. They remained happy bedfellows from an investment perspective. Then something went awry and forced a breakup. Is that just a 15 year rich or something worse or why did the relationship break down?
[00:07:03.210] – James Luke
No, I don’t think it was a 15 year rich. I think actually those two factors. So Fed policy and then western investment, demand for gold, for gold as a monetary asset, I think are still very, very much connected and we can really see that in the data. So this time round, as in 2013, the Fed has tried to normalise policy. They’ve started to reduce their balance sheet, i.e. reverse quantitative easing, and they’ve significantly raised interest rates, which has put the opportunity cost up of holding gold. And what have we seen? Well, we’ve seen physical ounces held in western etfs fall significantly, some 25 millionoz plus from the peak. In recent quarters. We’ve seen European demand for bars and coins fall very, very significantly, particularly in Germany. And we’ve seen pretty much very, very moribund financial market sentiment for the gold market. So I don’t think it’s that these relationships have suddenly disappeared. It’s just that their impact on the gold price has gone down because another buyer, another source of demand, has become so strong as to offset those negative selling pressures in the west. Real interest rates really started to accelerate higher in early 2022. And it’s at that point that the paths of gold prices and real interest rates really start to diverge. With gold prices since early 2022 having fluctuated between, say, below $1800 an ounce, up to above $2,000 an ounce, but really staying relatively high versus what real interest rates have done. It’s very, very clear that the pivot point was the first quarter of 2022, and that coincides perfectly with the Russian invasion of Ukraine. The biggest delta on the gold demand side has really been central bank demand. And I think that central bank demand has been directly related to the Russia-Ukraine invasion and the western response to it. So whilst the west hasn’t officially confiscated Russian reserves, it has effectively frozen upwards of half a trillion dollars worth of Russian FX reserves. And I think that’s had a, one can speculate that may well have had a significant impact on gold purchasing patterns among other central banks who feel that in any future conflict with the US they might be nonaligned with the US. And I think China probably looms large in that conversation.
[00:09:49.370] – David Brett
Central bank demand for gold had been net positive since 2008, but over 2022 and 2023, it has almost doubled the post 2008 average. And why are they buying gold specifically?
[00:10:02.710] – James Luke
I mean, if we take China as a specific example, I think the first point to make would be they really don’t hold very much gold compared to, say, western central banks as a percentage of reserves or compared to other emerging market counterparts. So, for example, Russia owns about 20% or has about 20% of its FX reserves in gold. Turkey is a similar number, whereas Chinese reserves, even with the buying that they’ve been doing over recent quarters, have only moved from, say, 3% of reserves to 4%. So the starting point is extremely low. I think also gold is, as we discussed, outside the US dollar system, it can’t be confiscated, it’s held domestically. And so it is a hedge very much against any future deterioration in relationships or any kind of catastrophic breakdown.
[00:10:58.590] – David Brett
And is demand just limited to central banks?
[00:11:01.000] – James Luke
The biggest change, so the biggest delta has come from central banks. But it’s also true that demand for gold bars and coins has been very, very strong in China and also in places like the Middle East, reaching clear record levels in the World Gold Council data. I think, again, China looms large. It’s a very, very interesting trend there. And I think, again, if you compare 2013 or even earlier periods in terms of Chinese retail demand or public investment demand, there’s a stark contrast. And I think a lot of that comes down to structural issues with things like the Chinese property market. The Chinese property market has been this absolute beer moth for the last two decades and has been a significant destination for investment capital and surplus liquidity in the Chinese economy. And now that that channel has, from our perspective, been killed stone dead structurally, by changes in the policy stance from Beijing, capital lacks a home to go to. And I think gold has been absolutely a beneficiary of that.
[00:12:23.150] – David Brett
So if there’s so much of this demand from central banks, why has gold not gone higher than it is?
[00:12:29.660] – James Luke
Yeah, no I think that the factors that we’ve talked about come together quite nicely to explain why gold is here. You’ve had rampant increases in demand from central banks, very strong bar and coin demand in the East. But offsetting that, you’ve had what you could describe as a predictable reaction from western holders of gold to monetary policy tightening. So you’ve had western selling, western liquidations, offsetting the demand increases that I’ve mentioned.
[00:13:01.500] – David Brett
The way James views the market is that it’s only that western selling of gold that’s kept the gold price below those all time highs. What would happen if those sellers suddenly became buyers?
[00:13:14.390] – James Luke
Yeah, I think if you look into 2024, if you were to imagine a scenario where the US was heading more soundly into the kind of downturn that pretty much consensus was widely expecting to happen in 2023, and you were to imagine a situation where ETF liquidations had stopped, investment interest in gold was coming back in the US and in Europe. And at the same time that structural central bank bid remained. I think if you had that coordinated demand impulse coming from both the West and the East, then you could see surprisingly strong trends in gold prices that would really, really shock investors. So we think it’s very, very conservative to say that when we look into 2024, we expect to see $2,000 an ounce become support in the gold market, rather than the resistance that it’s been for the last three years.
[00:14:11.430] – David Brett
Arguably, all those scenarios described are on investors minds already. And if things were to change and Westerners decide they need some safety in potentially turbulent times and they turn their attentions to gold, what does that mean for gold producers?
[00:14:27.470] – David Brett
As we described when we were talking about the gold market, what we’ve really seen is Western bearishness offsetting Eastern bullishness. We’ve seen ETF selling and bar and coins selling from Europe and the US offsetting very strong Chinese central bank demand, very strong Chinese and Middle Eastern bar and coin demand, but still gold prices at very, very high levels, in fact, record quarterly average records. And yet that same negative sentiment that. Has come from the west in terms of bullion markets is also what’s impacting, I think, the valuations of gold producers. Because while, of course, it’s true that cost inflation was an issue in 2021 and into early 2022, it’s also true that you have very, very healthy business fundamentals and very, very healthy margins, cash flow margins at these gold prices. It’s just that the Western investor, on average, has no faith in the long term sustainability of gold prices, and therefore the long term sustainability of those cash flows. I think if our scenario plays out and $2,000 per ounce becomes support rather than resistance, then to be honest and without meaning to sound too much like a hyperbolic fund manager, I think the impact on valuations for gold producers would be absolutely transformational and I think that’s because really they’re coming from such a low base that the disconnect that we’ve seen between gold producer valuations and the underlying bullion price is dramatic and is at a record. And so yes, I think the potential for those equities to play catch up would be absolutely huge.
[00:16:29.910] – David Brett
Well, that was the show. We very much hope you enjoyed it. If you want to find out more, please head to schroders.com/Insights and we’re endeavouring to record as many of these shows in the studio on video. And if you want to watch them in their full, unabridged version, then go to Schroders’ YouTube channel if you want to get in touch with us. It’s Schroders’ [email protected] and remember, you can listen, subscribe and review the investor download wherever you get your podcasts. New shows drop every Thursday at 05:00 p.m. UK time, but above all, keep. Safe and go well. Cheers.
[00:17:06.210] – Disclaimer
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Originally Posted December 27, 2023 – Podcast: The case for gold in 2024
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