Gold won't help in a crisis

A new working paper from the US-based National Bureau of Economic Research (Gold's Value as an Investment, Working Paper 31386) attributes the majority of the value of gold since 2007 to its role as an investment asset whose price is directly related to shifts in bond prices.The paper's author, Urban Jermann, borrows from the methodology adopted in fixed-income derivative pricing models to differentiate the impact on prices of industrial users of gold from that of financial investors. Jermann, Professor of International Finance and Capital Markets at the Wharton School at the University of Pennsylvania, hypothesises that gold prices contain an implied option value based on the demand for the metal by those using it for "its good looks and conductivity". This option value provides a theoretical floor price which would be activated even if investment demand fell to zero. "Because of gold's potentially long duration, this option value could be very high", he says. Because it does not have a financial yield, gold should become a more attractive store of value in times of low interest rates. Consistent with the theory, gold price movements over the past five decades are inversely correlated with US government bond yields.The Jermann paper is useful in highlighting the clearly non-linear nature of this relationship, in practice. A scatter diagram showing the gold price as a function of the 10 year US government bond yield is ‘L-shaped' rather than continuously downward sloping.Jermann correlationsAt relatively low interest rates, the connection is very much as expected with a strong negative correlation evident. Small movements in the bond yield have been associated with large gold price shifts.As yields pass through approximately 4.5% the relationship quickly changes direction from downward sloping to flat lying or even gently rising.Jermann concludes that the high correlation coefficients "make it clear that long-term real rates can be considered the main driver of gold prices during the low-rate periods".On the other hand, "during high-rate periods the correlation between changes in gold prices and yields is typically lower", he says. When interest rates are high, investment demand declines and the commodity demand for gold becomes correspondingly more important for price outcomes. The size, and impact, of these non-financial purchases depends on the extent of wealth accumulations associated with rising incomes.Jermann also investigates the impact of exchange rates noting that "considering that gold users are to a large extent non-US residents who are not using the USD as their numeraire creates a role for the real exchange to affect the price of gold".Low rates have been very much a post-2007 phenomenon. In contrast, high rates characterised the prior three decades.Overall, says Jermann, "the mechanisms and the factors represented in this model can reproduce a significant part of the gold price fluctuations since 2007". However, the Jermann model clearly shows that different forces were at work before around 2007.The 2007 point of inflection poses a challenge for anyone trying to derive a gold price model from the entirety of the post-1970 historical data. What explains pre-2007 movements struggles to deal with what happened after 2007 and vice versa.Critically for present-day forecasters, the point of inflection in the relationship is very close to current market prices with the 10-year US bond yield presently sitting near 4% having risen from levels below 1% and having briefly touched 4.25% within the past nine months.Financial markets are hovering around the junction between bond prices being of primary importance and, a just few basis points away, becoming a negligible influence. If yields were to push much higher in the year ahead, gold price volatility due to interest rate changes would sharply decline, if the historical record is any guide. If, on the other hand, US interest rates were to fall from current levels, the positive response from gold prices would likely be strong.At the June 2023 meeting of the US central bank's open market committee, the majority of participants projected at least a 0.5 percentage point rise in the Fed Funds rate from the present 5.1% during the balance of 2023.Fed governors projected a subsequent decline in rates during 2024 and a further drop in 2025 as the policy rate headed back to a longer-term level about half of what it is today.Federal Reserve Outlook The Federal Reserve outlook, if it came to pass, would be consistent with stronger gold prices in the coming year or two as both nominal and real bond yields, based on movements in policy rates, decline and inflation moves lower.Nearly 90% of the gains in the gold price over the past 50 years have occurred during three periods. A $420/oz rise in price during the 1970s and a $390/oz push higher between 2002 and 2007 came in periods of high interest rates but also huge wealth accumulations in the middle east and China. The third period between 2008 and 2011 was an unusually powerful combination of falling bond yields and continued strong income and wealth expansion in China as that country's economic growth reached a crescendo.Without drivers of demand equivalent in impact to the accumulation of petro-dollars in the 1970s or Chinese industrialisation in the early 2000s, large gold price shifts are unlikely in the presence of high interest rates.The Jermann paper emphasises that the primary drivers of gold vary, depending on the surrounding circumstances. The hard empirical evidence suggests that gold thrives on either strong positive wealth effects or unusually low and falling interest rates.In the event of a growth crisis or geopolitical instability which threatens wealth accumulation, gold prices should not be counted on for protection.

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