Is Gold an Inflation Hedge or a Political Hedge?
Key Takeaways:
1. Big spikes in the gold price are not really following moves in inflation, indicating that gold may not be the inflation hedge that many people think it is.
2. There is a compelling case for viewing gold as an anti-dollar asset, particularly in the current macro and geopolitical climate.
3. There has been a strong central bank appetite for gold, and this will sustain demand for the precious metal in the years to come.
Gold has long been regarded as a safe haven asset by investors and bankers alike. Recent surges in inflation and geopolitical uncertainties have sparked further interest in the precious metal, ultimately driving its price close to all-time highs.
At first glance, this enthusiasm for gold as an inflation hedge seems justified. As the common thesis posed, gold’s quantity is limited and, unlike fiat money, you cannot print it, making it the perfect anti-inflation safety bet.
Yet, a close examination of gold's performance challenges this conventional wisdom, and reveals a complex picture that carries important implications for investors.
Gold as inflation hedge
Looking at the trajectory of gold relative to US dollars since 1975 and overlaying the US consumer price index, it becomes evident that significant spikes in the gold price do not consistently correspond to rising inflation.
Source: Data from investing.com; author’s calculation
Surprisingly, even during the last three years when inflation exploded, gold prices traded in all directions, indicating a weak correlation between the two.
Not only does gold’s performance fail to align with actual inflation rates, but it also shows limited correlation with inflation expectations. Examining the Federal Reserve Bank of New York’s inflation expectation survey uncovers that this forward-looking metric does not strongly correlate with gold’s performance.
Additionally, the yield environment plays a crucial role in shaping gold’s appeal. Since the asset does not offer carry, dividends or interest, high yields,which typically materialize in response to rising inflation, dampen its attractiveness.
Considering these factors, it becomes clear that gold’s connection to inflation is more nuanced than previously believed. At most, it could be deduced that inflation is a lagging indicator for gold.
Gold as anti-dollar
Instead, a compelling case can be made for viewing gold as an anti-dollar asset, particularly in the current economic climate.
Gold is most often discussed in dollar terms. Though, amid geopolitical uncertainties and concerns over the future of the US dollar as the world’s reserve currency, investors are increasingly turning to gold as an alternative to holding dollars.
Today’s macro variables stand out as particularly fertile for investors to adopt such a stance. Western sanctions against Russia and the fears surrounding the dollar-dominated financial order have intensified this sentiment leaving many to equate the move as the weaponization of the greenback.
More recently, the debt ceiling dysfunction and the uncertainty around future Fed moves are pouring further fuel on the fears that surround the fate of the US dollar and its status as the world’s reserve currency, with some pointing to signs of a crumbling dollar-denominated financial order.
Against such a challenging backdrop, investors are increasingly turning to gold to avoid holding dollars.
But can’t you simply hold other currencies to avoid the US dollar? The obvious alternatives would be the Euro, Sterling or Yuan, but two of these have the same drawback in terms of weaponization and sanctions, the other has currency controls. The politics are just as problematic as the US for different reasons, and the bond markets are also much smaller and less stable.
Notable gold price surges, such as those witnessed in 2005-2011, 2019-2020 and in 2022 are just as clear if you look at the price versus EUR, GBP or CNY, which indicates that gold outperforms any other dollar alternatives.
Gold as central bank reserves
Another crucial factor shaping gold’s recent trading patterns in central bank demand.
While allocation to gold among central banks varies greatly, the World Gold Council’s data indicates that top reserve-holding countries/regions largely have single-digit gold allocations.
Source: World Gold Council (as of 4 June 2023)
However, central banks are currently gobbling up gold at the fastest pace in decades, with 2022, the year when Russia’s foreign currency reserves were frozen, witnessing the highest increase since 1987.
The primary buyers include China, Kazakhstan, Russia and Turkey; nations often at odds with the US diplomatically are diversifying their reserves away from the US dollar, which they perceive as less secure.
This makes sense: if you are a central bank in a country which might at some stage consider not aligning with the US on matters of international policy, holding a large proportion of your reserves in US dollar doesn’t seem so safe.
But how fast can a central bank build up its gold reserves? Gold production typically amounts to 3-4 tonnes a year. Approximately 30% of the output is utilized for jewellery, leaving around 2.5 tonnes for industrial use, private investment and central bank acquisition.
Such limited supply undermines the ability of central banks to purchase gold in large quantities at high velocity.
Consequently it could take several decades for the largest buyers to reach the reserve levels seen in Germany, France, Italy, the Netherlands or the US.
Implications for investors
Despite questions surrounding gold’s efficacy as an inflation hedge, the combination of increased investor interest in diversification away from the US dollar and the strong central bank appetite for gold is expected to sustain demand for the precious metal in the years to come.
What’s more, as geopolitical tensions persist and central banks seek to secure their reserves, gold’s role as a political hedge is becoming increasingly prominent.