The Real Reason Gold Hasn’t Exploded

The world has changed radically in recent years. We’ve had the worst pandemic since 1918, and the third worst in world history. We’ve had a global supply chain breakdown. Inflation has been the worst since the early 1980s, despite the fact that it’s come down since peaking last June.

Meanwhile, Europe is experiencing its worst war since the end of World War II.

That kinetic war in Ukraine has been accompanied by a financial and economic war between the U.S., the U.K., the EU and Russia that involves extreme financial sanctions, including seizing the central bank reserves of the world’s 11th-largest economy.

That financial war and accompanying sanctions disrupted supply chains on top of the disruptions that were already present. They still persist.

And the world’s second-largest economy, China, locked down 50 million people in Shanghai and Beijing for months in a hopeless and misguided effort to suppress COVID. (China has finally seemed to learn that the virus goes where it wants). Meanwhile, tensions in the Taiwan Strait are high, with a lot of talk about a potential Chinese invasion or blockade of Taiwan. The list goes on.

If gold is the ultimate safe haven for investors and the world has been dangerously unsafe, then the price of gold must have been skyrocketing, right?

That’s not the case. Today gold is about $2,030 per ounce after gaining over $200 in the last month (that price fluctuates daily and intraday). That’s still lower than the $2,069 all-time high of Aug. 6, 2020.

The bottom line is, gold is lower today than it was three years ago. There have been some spills and thrills along the way including two peaks over $2,000 and several smashes down into the $1,680 range, but always followed by a reversion to a persistent central tendency that hasn’t moved much at all.

So, we’re back to the original question. With inflation, shortages, and war all around, why is gold not surging past $3,000 per ounce and making its way to $4,000, $5,000 and beyond?

Supply/demand conditions favor higher gold prices. Global production of gold has remained fairly constant for the past seven years. Over the same seven-year period, during a period when global output was flat, central banks increased their official holdings by over 6%.

China has added over 1,400 metric tonnes in the past thirteen  years (that’s the official number; unofficially they probably own far more). Russia has acquired over 1,500 metric tonnes over that same period.

Other large buyers have included Poland, Turkey, Iran, Kazakhstan, Japan, Vietnam and Mexico. Central banks in the Visegard Group (Czech Republic, Hungary, Poland and Slovakia) have also bought gold.

What’s curious is that individual investors in the U.S. still seem indifferent to gold as a monetary asset. In theory, central banks are the most knowledgeable about the real condition of the global monetary system. If central banks are buying all the gold they can with hard currency (dollars or euros), it’s not clear what retail investors are waiting for.

Of course, central bank holdings are only about 17.5% of total above-ground gold and there is far more demand from bullion investors and for jewelry (a form of wearable wealth). Still, central banks are arguably the most knowledgeable market participants; and their steady increases in gold holdings is meaningful.

Interest rates also play a supporting role. Many of the directional moves in gold prices over the past three years have been tied to interest rate moves. The correlation is not perfect, but it is strong.

The rally in gold prices in late 2020 was tied to a fall in interest rates (yield-to-maturity) on the 10-year U.S. Treasury note from 1.930% on December 19, 2019 to 0.508% on July 31, 2020.

Similarly, the fall in gold prices after February 2021 was tied to an increase in interest rates on the 10-year Treasury note from 1.039% on January 2, 2021 to 3.130% on May 2, 2022. Rates are 3.44% as of today.

But I believe that interest rates on the 10-year Treasury note will fall again and will continue to fall as global growth weakens. That’s good news for gold investors. Short-term rates have gone up because of Fed policy, but long-term rates will go down because investors see that the Fed will cause a recession. That correlates with higher gold prices.

While market supply/demand conditions are favorable for gold, and the overall interest rate environment is also favorable for gold, neither has seemed to have the power needed to push gold sustainably past $2,000.

What’s the problem?

The real headwind for gold and the main reason gold has struggled to gain traction for the past three years has been the strong dollar.

After all, the dollar price of gold is really just the inverse of the strength of the dollar. A weaker dollar means a higher dollar price for gold. A stronger dollar means a lower dollar price for gold.

It may seem paradoxical to imagine a strong dollar in the midst of all the inflation we’ve been seeing. But that’s the case.

What’s extraordinary over the past three years isn’t that gold hasn’t soared; it’s that gold has held its own in the face of a persistently strong dollar. So that leads to the next question:

What’s been behind the strong dollar and what could cause the dollar to suddenly weaken and send gold prices into the stratosphere?

The strong dollar has been driven by a demand for dollar-denominated collateral, mostly U.S. Treasury bills, needed as collateral to support leverage on bank balance sheets and in hedge fund derivatives positions.

That high-quality collateral has been in short supply. As banks scramble for scarce collateral, they need dollars to pay for the Treasury bills. That fuels dollar demand.

The scramble for collateral also speaks to fears of a banking crisis in the wake of SVB’s collapse, weaker economic growth, fears of default, decreasing creditworthiness of borrowers and fear of a global liquidity crisis. We’re not there yet, but we’re getting close with no relief in sight.

As weak growth turns into a global recession, a new financial panic will be on the horizon. At that point, the dollar itself may cease to be a safe haven, especially given the aggressive use of sanctions by the U.S. and the desire of major economies such as China, Russia, Turkey, and India to avoid the U.S. dollar system if possible.

When this panic hits and the dollar is deemed no longer reliable, the world will turn to gold.

Frustration with the sideways movement of gold prices is understandable. But behind the curtain, a new liquidity crisis is brewing.

Investors should consider today’s prices a gift and perhaps a last chance to acquire gold at these prices before the real safe haven race begins.

Even above $2,000, gold is so cheap right now, it’s practically a steal.