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Wednesday, July 29, 2020

Is The Price Of Gold Telling Us Something?

U.S. Dollar Price of Gold

Gold prices have been rising in a parabolic fashion again, and catching some interest. If one owns gold, congratulations. One of the usual ways to fill up column inches in commentary is to discuss what information about the economy and/or financial markets gold is providing. The most likely answer is that portfolio managers feel that other portfolio managers want to buy gold, so they hopped on the bandwagon. This offers us zero useful information for the macroeconomic outlook.

(As a disclaimer, I have a small position in a Canadian gold miner ETF, plus the Canadian index ETF's presumably have a decent weighting in gold stocks. At this point, I am not entirely sure why I entered into the position. My bias is to own the producers of commodities and not the commodity itself.)

The configuration of the gold market is straightforward.
  • There is a relatively small flow of gold towards industrial uses, as well as jewelry.
  • There is another flow of gold coming from mines (and recycling).
  • A certain amount of gold is held in the form of coins (and similar) by the public. These coins may be traded among households, but the flow from this stock to the wholesale markets is normally low. (During the 1970s precious metals bubble, a lot of gold and silver supply was brought in for scrap value, creating a supply response to rising prices in the wholesale markets.)
  • Central bankers and investors have a large stock of gold in vaults, and transact in wholesale markets.
  • There are derivatives layered on top the wholesale markets that derange some gold fans.
The key is that the industrial and mining flows are small relative to the stock, and so there is no reason for the commodity price to remain attached to production costs or the demand curve for industrial use. This is very different than a commodity like wheat, or even oil (which is stored). Since gold is not tied via relative prices to the price level, it is not particularly useful as a unit of account.

Meanwhile, the value of the stock of gold represents a small percentage of global financial assets. The price can be pushed around by extremely small portfolio shifts. It is safe to say that this is exactly what is happening: portfolio managers have decided to ramp up the price, following a pretty exponential growth trajectory.

If we look at the previous ramp off the bottom in the early 2000s, we see that the trajectory was largely unperturbed by the economic cycle (although there was a wiggle during the Financial Crisis). It rose through the expansion, paused slightly during the recession, then collapsed once fears of hyperinflation caused by QE faded. Interest rates went up and down, and inflation did absolutely nothing interesting (modulo the oil price spike that came and went).

One can attempt to come up with an elaborate theory explaining the price movements. But since this is just Keynes' beauty contest, it is purely a question of finding what theory other portfolio managers believe in. Since prices are detached from any fundamental valuation metric, these belief systems are essentially arbitrary. All that can safely be said is that the price will be ramped up until is starts falling, and then the cycle repeats.

(c) Brian Romanchuk 2020


  1. So isn't gold negatively correlated with USD index? as in fear of weaker dollar in the future pushes gold price up, i.e gold is an alternative unit of account of USD.

    1. Gold fell like a rock from 1980-2000 (roughly), the dollar did all kinds of stuff. Any correlations are temporary when you look at the long term.

      Since pricing is entirely driven by fads by traders, they seize on whatever correlation catches their interest at the time. You just want to catch onto the fad before the other trader.


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