By Rick de los Reyes, head of commodities at T. Rowe Price
Gold has been prized as a store of value for thousands of years. In fact, up until the US abandoned the gold standard in 1971, major fiat currencies were backed by defined amounts of gold and were exchangeable into gold at any time.
Although we are no longer on a gold standard, gold continues to be viewed as a stable currency because it is naturally scarce. It cannot be willed into existence the way fiat currencies can be easily manufactured by central banks.
When governments get into a financial bind, it is far too easy to debase currencies by manufacturing more of it. it is because of this possibility of having one’s savings wiped out by profligate governments that gold continues to maintain its popularity as a stable store of value.
Gold and dollar relationship decoupling
For decades, there has been a generally stable inverse relationship between the US dollar gold price and real interest rates. This makes sense given gold has no yield. If real interest rates are high, there is an incentive to hold dollars given its ability to generate real income. Conversely, as real interest rates fall or even go negative, the incentive to hold dollars declines and the gold price rises.
However, this relationship noticeably decoupled starting in late 2022. One potential explanation is that gold is impacted not just by monetary policy, which determines interest rates, but also by fiscal policy. When the US government runs large budget deficits and increases the national debt at an accelerated rate, it is essentially debasing the currency. Increased liquidity from loose fiscal policy more than offsets monetary tightness – this scenario leads to a higher gold price.
To be clear, this is not just a US phenomenon. Nearly all currencies are debasing by increasing supply at a rapid rate. This is why we have seen gold decouple from the relationship between the dollar and other major currencies. It is not about dollar versus euro or yen. Instead, nearly all fiat currencies are debasing versus gold.
Central banks add to gold reserves
Another driver of gold price strength has been a strong increase in central bank buying. This buying is likely driven by several foreign countries’ desire to decrease dependency on the dollar as the world’s reserve currency.
Implied central bank buying increased significantly in 2022 and it is unlikely to be a coincidence that 2022 was also the year the West froze hundreds of billions of dollars of Russian currency reserves held in foreign banks as a response to Russia’s invasion of Ukraine. Other countries, including China, quickly realised they had best secure their own reserves to try and avoid the risk of running afoul of the US and its allies in the future. Buying gold was one way to do this.
Importantly, the gold market is nowhere near the size necessary to completely replace foreign currency reserves. According to the World Gold Council, all the gold mined in human history is worth about $12trn. While this sounds like a big number, it is only a small fraction of the hundreds of trillions of dollars of financial assets in the world. This means central banks would need to continue adding to gold reserves slowly and methodically for a long period of time if they hope to make gold a more meaningful part of their reserve portfolio.
Dual fiscal and monetary tailwinds
The trends discussed above seem unlikely to abate anytime soon. The US government will likely continue to run large fiscal deficits, as neither major party seems to now stand for fiscal conservatism. Also, geopolitical risks only seem to be growing. The coalition of countries hostile to the West will continue to look for ways to decrease dependency on the dollar as a reserve currency and medium for international exchange.
For these reasons, we believe it is important to consider some exposure to gold and a diversified set of other commodities through commodities-related equities. As a pure financial asset, gold tends to move first as it reacts most immediately to the debasement of fiat currencies. But, over time, debasement is inflationary and should be reflected in rising prices of industrial commodities.
With the Federal Reserve seemingly at the beginning of a rate-cutting cycle, commodities now have the potential to benefit from the dual expansionary tailwinds of both fiscal and monetary policy.
