GOLD`S RUN ISN`T YET DONE / THE FINANCIAL TIMES MARKETS INSIGHT

Gold’s run isn’t yet done

Fiscal burdens, sovereign buying and positive bond-equity correlation continue to support the precious metal

Bhanu Baweja

The current rally began in 2018 and has thus far returned 19% annualised © Michael Norcia/Sygma/Getty Images

Between 1834 and 1971, the US dollar’s value was defined in terms of a fixed quantity of gold. 

After the collapse of the Bretton Woods regime in 1971, gold began trading freely and has since experienced three major bull markets: 1971-80, 1999-2011, and a third phase that began in 2018. 

We believe this latest advance has further to run.

In its first bull market through the 1970s, gold posted 46 per cent annualised gains over eight and a half years, among the most dramatic revaluations of any major asset in modern history. 

This reflected a collapse in the postwar monetary order, deeply negative real interest rates, geopolitical uncertainty and widening fiscal deficits. 

The second bull run saw gold become financialised, lifted along with other commodities by Chinese demand and, again, by exceptionally loose US monetary policy. 

Annualised gains of almost 18 per cent were less spectacular but more sustained.

The current rally began in 2018 and has thus far returned 19 per cent annualised. 

It has come about as a result of familiar forces, falling real rates and Covid-era quantitative easing, but things changed fundamentally along the way.

For the first two decades of this century, a 1 percentage point move in US real rates typically coincided with a roughly 14 per cent move in gold in the opposite direction. 

That relationship ended in February 2022, when western governments froze Russia’s foreign exchange reserves. 

Reserve and asset managers globally were left confronting a simple question: if $630bn held in Treasuries, Bunds, gilts and other bonds could become inaccessible overnight, what constituted money? 

Their answer was gold. 

Emerging market central banks and sovereign funds have since increased gold allocations from 5 to 7 per cent of reserves in 2022 to 11 per cent today, still short of the 26 per cent held by developed-market peers.

Between March 2022 and October 2023, US five-year real yields rose more than 4 percentage points. 

Based on historical relationships, gold should have fallen about 55 per cent; instead, it rose 7 per cent. 

Over the following two years, real yields fell less than 1 point while gold rallied 110 per cent. 

Gold is now far more responsive to falling real yields and less sensitive to their rise. 

This new asymmetry has rendered most existing fair-value models obsolete, with many signalling that gold has been extremely overvalued from $2,500 per ounce. 

These models have failed to capture two other variables.

The first, a cyclical factor, is positive bond-equity correlation. 

During the inflationary period of the past five years, bonds have often failed to hedge equity risk. 

Gold, by contrast, has generally provided superior diversification for equity-heavy portfolios. 

According to the World Gold Council, individual and institutional investors still hold only 3 per cent of their financial assets in gold; there is plenty of room for this to increase. 

When inflation and inflation volatility eventually decline, bond-equity correlation may turn negative again. 

Investors may then choose bonds more as a diversifier over gold, which yields no income. 

But we are not there yet.

A second, more structural driver of gold has been the gradual erosion of confidence in US public finances. 

In our models at UBS, this is captured by term premium, the extra yield investors demand to hold long-term bonds over short-term debt. 

It is becoming an increasingly important determinant of gold.

Already standing at $32tn, US public debt is likely to increase by as much over the next decade. 

Yet the US has shown a strong aversion to its most natural consequence: higher long-end yields. 

How might long-end yields be kept in check while the Treasury continues to run fiscal deficits of 6 per cent of GDP at full employment? 

One possibility would be to persuade the Fed to lower policy rates aggressively long term, even if it first needs to take them modestly higher in line with the two hikes being expected by markets. 

Both lower real rates and higher term premia should be supportive of gold.

There are early signs of fiscal dominance — where fiscal pressures shape monetary policy — emerging in the US. 

The phenomenon has long been visible in Japan, where the currency has paid a heavy price. 

France, Italy and China have precarious fiscal outlooks too. 

As markets assess how the fiscal piper will ultimately be paid, they have begun to put a modest but systematic premium on currencies of better-rated sovereigns such as Switzerland, Australia and Canada. 

But nowhere is that theme more manifest, or more investable, than in gold.

The writer is chief strategist at UBS Investment Bank