What is making the gold market run so hot?

An intriguing recent development in financial markets is the surge in gold prices. It is particularly striking given that gold did little to protect investors from the effects of accelerating inflation over the past two years. So why rally now? A complex interplay of known and potentially unknown factors makes the gold rally fascinating to analyse – and we focus on the metal in this week’s Simply put. 

 

Need to know: The recent surge in gold prices cannot be explained by the usual fundamental factors: inflation, real rates and risk aversion Some suspect that central banks’ purchases of gold have played a role A sense of bearishness arising from expensive equity markets could be another factor, and gold could be the mirror image of that development

 

What the typical factors suggest

The answer to what is driving the rally in gold prices may lie in a combination of factors, including real yields and shifting market sentiment. However, it's also plausible that other underlying factors, not yet fully understood or identified, are at play.

In May 2023, we penned a Simply put focusing on the fundamental factors influencing gold prices, noting that these were largely being overlooked by the market. They were:

1. Inflation, which generally acts as a positive driver

2.  Real yields, which typically have a negative impact

3. Risk aversion, which is another potentially positive influence

To assess how these factors have evolved, we examine their estimated contributions to gold’s performance over two periods: Q4 2023 and Q1 2024.

Figure 1 visually represents these dynamics. Over the fourth quarter of last year, gold prices actually fell short of what fundamental factors predicted, mainly because of declining real yields and the pervasive effects of October’s market volatility. Gold was expected to gain about 7% but only rose around 4%.

The opposite discrepancy emerged in the first quarter: while fundamentals predicted that gold’s performance should have been near zero, it actually gained about 8%. This suggests a potential ‘catch-up’ effect, with the gold price adjusting to previous fundamentals. However, the concurrent rise in real yields has puzzled market observers, hinting at other influences.  

 

FIG 1. Gold performance broken down across factors

Source: Bloomberg, LOIM. As at April 2024. For illustrative purposes only. Past performance is not a guarantee of future returns.

 

Gold reserves enter the picture

Identifying missing factors in the dynamics of asset or currency prices is a challenging endeavor. A practical approach often begins by comparing the price that a fundamental model suggests for an asset, such as gold, against its actual market price. The discrepancy between these two values can offer insights into what fundamental aspect might be overlooked.

Figure 2 illustrates this approach. The left side displays the outcome of our fundamental model, which currently values gold at approximately USD 1,700 per ounce. On the right, the chart traces the evolution of this discrepancy since 2003, juxtaposed against the evolution of central bank gold reserves, as an additional explanatory factor.

A closer examination of the chart clearly identifies central bank gold reserves as a potential missing link in our assessment of fundamentals. This correlation was particularly noticeable from 2003 to 2008, a period characterised by low gold purchases, and then from 2009 onwards when central banks significantly increased their gold acquisitions, averaging about 400 tons per year. However, while this factor has been influential, it alone cannot account for the recent dynamics of gold prices. As a sidenote, ETFs have not been attracting many flows recently, suggesting how the current extra demand seeks physical gold exposure – not a US/European habit, another interesting hint. Other elements may then be impacting gold's valuation, necessitating a broader investigation.

 

FIG 2. Fundamentals-driven fair value (left) vs. yearly changes in gold reserves, compared with gold price’s distance to its fundamental valuation

Source: Bloomberg, LOIM. As at April 2024. For illustrative purposes only. Past performance is not a guarantee of future returns.

 

What does gold say about stocks?

The lack of empirical evidence linking recent central bank gold purchases to changes in the metal's price has prompted some analysts to infer that the sudden demand for gold reflects a growing unease about more volatile assets, which have climbed this year. This hypothesis is underscored by the notable increase in gold prices during the first two weeks of April, potentially signaling a defensive shift among investors. Indeed, as credit spreads widened and implied volatilities increased during this period, gold prices ascended, suggesting that market sentiment may be partly driving this rally.

Another intriguing factor emerges when considering unexplained variations in gold prices. Figure 3 compares the distance between gold prices and their fair value to a gauge of US stock market attractiveness that uses the ratio of US corporate earnings (as per the GDP report) to the price of the S&P 500. When earnings growth outpaces stock prices, this ratio widens, indicating that the appeal of stocks has diminished. Historically, this metric has accounted for a significant portion of the discrepancies between gold prices and the metal’s fundamental factors. So, while stocks are near all-time highs, the gold market might be reflecting a temporary aversion to stocks among the broader investment community.

This sentiment aligns neatly with the current pause in the equity-market rally. It also could be a critical piece of the puzzle in understanding the recent movements in gold prices.

If there is one certainty with gold prices, it is that a flurry of factors will affect the direction of the metal’s price in the meantime. 

 

FIG 3. Fundamental mispricing vs the diminished appeal of US equities

Source: Bloomberg, LOIM. As at April 2024. For illustrative purposes only. Past performance is not a guarantee of future returns.

 

Simply put, the recent surge in gold prices reflects a multitude of factors, from inflation to risk aversion. Gold is probably a missing link in understanding the stabilisation of markets.

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Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises and global monetary policy surprises are designed to track the recent progression of macroeconomic factors driving the markets.

Our nowcasting indicators currently show:

• Our growth indicators rose slightly this week, with the exception of China, where the data deteriorated
• The inflation nowcaster continues its upward trajectory in the US, eurozone and China as inflationary pressures strengthen
• The eurozone monetary policy indicator fell slightly, while the US and China indicators rose during the week

 

World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)

World monetary policy nowcaster: long-term (left) and recent evolution (right)

 

Reading note: LOIM’s nowcasting indicators gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).

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