Gold is maybe the world’s oldest store of value that continues to be widely used. Yet it’s unimaginable to find out its intrinsic value. Why? Since gold generates no income, there isn’t any money flow to discount. In this respect, it is analogous to government debt in today’s developed countries. And just as gold was used to create money in earlier eras, government debt serves the identical purpose today.
The gold price (XAU) and the US dollar index (DXY) are likely to have a negative correlation, while the gold price and money supply (M2/GDP) have a positive correlation. This was essentially true from 2000 to 2020 and reflects how US dollars and gold served as official reserves of central banks and the way gold was denominated in US dollars within the Bretton Woods system.
When US monetary policy is loosened and the yield on risk-free dollar assets falls, the DXY also tends to fall while M2/GDP rises, resulting in an increase within the XAU. The continued rise in gold prices is consistent with the rapid growth within the US money supply following the resumption of quantitative easing (QE) in response to the COVID-19 shock. But the negative correlation between XAU and DXY seems to have all but disappeared.
Why did this occur and what else could gold bring? Before we are able to answer this query, we’d like to higher understand the historical context.
Gold prices (XAU) and dollar index (DXY)
Gold price (XAU) and US money supply (M2/GDP)
The decade-long gold bull market, 2000–2011
Gold prices bottomed out after the dot-com bubble after which began an 11-year rally. Gold prices are likely to rise with geopolitical crises. On September 11, 2001, it rose greater than 5% and on June 24, 2016, the day after the Brexit referendum, it rose ~5%.
Such events can have longer-term effects on the value of gold. For example, in response to the terrorist attacks of 2001, the US began wars in Afghanistan and Iraq. And from a budget surplus to budget deficits along with a large trade deficit. This triggered a chronic bear market within the US dollar that only ended when the worldwide financial crisis brought the economic system to a standstill.
The global financial crisis was the mother of all liquidity crises, and banks were desperate for the dollars they desperately needed. Within a number of months, the euro peaked against the dollar after which suffered considered one of the most important losses in its history. Margin calls needed to be met and gold prices plummeted in a wave of forced selling.
But then the US Federal Reserve stepped in to stabilize the markets and provided unprecedented dollar liquidity through QE. The forced selling stopped and the value of gold rose sharply again. It was only the European debt crisis that put an end to the metal’s decades-long bull run.
Downward correction phase of the gold price, 2011–2015
At the onset of the European debt crisis, concerns a couple of potential collapse of the euro and negotiations over the US debt ceiling increased demand for gold. The XAU peaked in September 2011, just because the DXY bottomed out and started a sustained uptrend. With Greece getting ready to default and the long run of the euro at stake, some liquidity-conscious European banks can have exchanged their gold reserves for dollars.
Meanwhile, the US economy raced toward full employment, increasing demand for US-denominated assets. The DXY rose again after the 2014 oil crash and gold prices collapsed. When Europe finally got here to Greece’s aid in 2015, liquidity concerns eased, the DXY plateaued, and gold prices began to get well.
The second bull run, 2015–2020
Since the low point in late 2015, the value of gold has been on a roll, for ever and ever. As Europe has steadily moved toward a fiscal union, as we predicted, and the US has struggled with its response to the COVID-19 pandemic and social and political unrest, the DXY has fallen only barely. And this despite the US accelerating monetary expansion within the face of the pandemic. Since there isn’t any negative correlation between gold and money supply, the present gold rally is different.
So what does this mean? In our view, the introduction of QE by the European Central Bank (ECB) has distorted the negative relationship between XAU and DXY. It has strengthened each gold and the dollar: EUR/USD has largely traded across the 1.10 mark for the past five years, in comparison with 1.20-1.50 within the five years before that. In 2015, the ECB switched from a conservative monetary policy based on the traditions of the German Bundesbank to a looser, more Fed-like approach.
With the 2 largest central banks printing a lot money to combat the COVID-19 crisis, the dollar and euro must have been losing value against gold. But gold’s rise – and the accompanying heightened investor unrest – predated the pandemic. After all, gold and DXY rose dramatically after the Brexit referendum on fears that the post-war global political and financial order might be shaken.
The continued rise of populist movements around the globe confirms this fear and will indicate a restructuring. Globalization appears to be going into reverse in lots of areas. With already strained geopolitical and financial structures further strained by the pandemic, rising gold prices might be an indication of trouble ahead.
What can we do now?
The inverse relationship between gold and the dollar stays stable over the long run. For example, real and potential liquidity crises (GFCs) are likely to cause gold prices to fall as banks and investors convert the metal into money. But then central banks step in and flood the system with liquidity, and costs get well.
The same mechanism is at work with the pandemic. With the ECB and Fed pumping money into the economy, the DXY remained relatively stable until recently. (There has been a major decline since we conducted this evaluation.) So whatever happens, the dollar will move based on the relative strength of the European and American economies and the political environment. In times like these, when monetary and financial policy have never been so loose, gold could proceed to succeed in recent heights.
Three scenarios
So what might this mean for the value of gold? To discover, we used easy econometrics to estimate a quarterly “error correction” model for the value of gold as a function of its key fundamentals: DXY and M2/GDP within the United States.
Below is the long-run equation estimated from the primary quarter of 1981 to the primary quarter of 2020, covering 160 observations. Following convention, we have now deflated the gold price by the buyer price index; the t-statistics are given in parentheses.
The unexplained remainder is the degree of over- or under-shooting. If all variables are converted to logarithms, the coefficients might be interpreted as elasticities. According to this estimation, the impact of a 1% increase in DXY on XAU/CPI is -0.67% and that of a 1% increase in the cash supply to GDP ratio is 2.77%.
Before using this model for forecasting purposes, there are several points to contemplate. Since the correlation is 72%, the model explains not more than 25% of the variation within the (deflated) price of gold. This is partly since it ignores the dynamic effects inherent within the evolution of asset prices: for instance, a “momentum” effect, when the value of gold moves since it has moved that way prior to now; or an “error correction” effect, when the value moves since it has exceeded or fallen wanting fundamentals. To address this, a short-run equation might be added to the model to clarify the value change through its own one-quarter lag, the momentum effect, and the one-quarter lagged unexplained residual of the long-run equation, the “error correction mechanism”, or the lagged residual of the long-run equation via ECM.t-1:
From this model, we have now created three scenarios for the gold price through the last quarter of 2021 based on forecasts of fundamental data. Although the model predicts the gold price, we are able to predict the implied price based on a forecast of the Consumer Price Index (CPI), which we expect to extend by 2% annually.
Three scenarios for the gold price
1. No change in the basics
This scenario assumes that M2/GDP and DXY remain at their last observed quarterly levels, so the value of gold would rise barely to ~$1,900 and stabilize there in 2021. This might be an unlikely end result if QE-fueled monetary growth continues as expected.
2. Sustained monetary expansion
The money supply to GDP ratio has generally been rising by about 1 percentage point per quarter through 2019 and early 2020. If this trend continues through 2021 and the whole lot else stays unchanged, the value of gold could reach $2,400 within the last quarter of 2021. This appears to be the way more likely scenario and will indeed be relatively conservative. If anything, money creation will only speed up.
3. A weaker dollar
The DXY has gained some strength since early 2019. More recently, because the ECB reinstated QE in response to the pandemic, the euro has lost value against the dollar. But depending on how the pandemic unfolds, the DXY’s uptrend could reverse. It could even reach its 2008 low by the fourth quarter of 2021. Our calculations, which assume continued QE, suggest that a price of $3,000 per ounce is feasible.
All in all, this can be a bullish outlook for the gold price. We see little downside risk and expect the gold price to fall into a variety between $1,900 and $3,000 over the subsequent 18 months.
This implies that considered one of the world’s oldest stores of value could also be storing much more of it in the approaching months.
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Photo credit: ©Getty Images / Bloomberg Creative
