How has the gold price defied its key macroeconomic headwinds?

Gold ETFs have been dumping gold

Gold bullion ETFs are the key swing factor in the physical gold market today, accounting for up to 20% of demand when investors are buying gold through this mechanism or up to 20% of supply when investors are making withdrawals.

Gold bullion ETFs (exchange traded funds dedicated to holding gold bullion) have been net sellers of gold bullion since the second quarter of 2022. The total volume sold over this time (to 31 December 2023) is equivalent to 7% of physical gold supply. The key driver of this has been rising real yields (the nominal yield on a 10-year US Treasury minus expected inflation – and relates to the opportunity cost of holding gold bullion, which doesn’t have a yield) and a strengthening US dollar. The real yield on 10-year US Treasury bonds increased by a staggering 304bps (from negative 52bps at the end of March 2022, to peak at positive 252bps in October last year) and the trade-weighted US dollar index appreciated by 8.4% over the same time period.

Real yields and the US dollar are the key fundamental drivers of the gold price. There has been a 0.7 correlation between the gold bullion price and real yields (inverted) over the last 20 years. Notwithstanding these fundamental headwinds, the gold price appreciated by 7% during this period (from US$1,937 per ounce to US$2,077 per ounce).

Central banks have been buying gold at rates not seen for decades

The reason for the strong gold price notwithstanding the fundamental pressures was a significant increase in gold buying by central banks which more than accounted for the gold sold by ETFs. The catalyst for this occurred when Russia invaded Ukraine and Russia’s foreign currency reserves were frozen. This has resulted in central banks buying gold in volumes not seen since the 1960’s, breaking a long-standing level of demand. Purchases of gold by central banks has accounted for 24% of demand since the Russia/Ukraine conflict began, more than double the post-financial crisis average of c.10%. Central banks appear to be much less sensitive to real yields and the US dollar.

Today, all central banks combined hold c.36,000 tonnes of gold which accounts for c.16% of global foreign reserves and c.17% of all the gold bullion in existence. Gold as a proportion of reserves varies significant between central banks with the United States among the largest at c.70% (and by volume with over 8,000 tonnes). It may prove relevant that China, India and Russia all have gold holdings significantly below the global average at 4.3%, 8.8% and 26% respectively. There is clearly scope to see central banks increase gold reserves after decades of declines.

Developed market central banks haven’t been significant buyers since the 1960’s and following the easing of geopolitical tensions at the end of the Cold War in the 1990’s, gold has been falling as a proportion of central bank reserves (although very little gold has actually been sold by central banks since the financial crisis). We believe the pattern has changed and that we have seen an upward shift in central bank appetite for gold as a reserve asset. History indicates central bank buying patterns run for long periods of time. If this thesis proves correct it may have placed a floor under the gold price and introduced a secular tailwind.

What next?

The next major catalyst for gold that we see will be a shift from ETFs being net sellers to net buyers of gold bullion, driven by the trajectory of real yields and US dollar.

A ‘pivot’ from the US Federal Reserve would be a catalyst for the formation of macroeconomic tailwinds for gold. It is worth remembering history in relation to Fed pivots (when the Fed signals a reversal of its existing monetary policy stance, e.g. from contractionary to expansionary). The ‘Fed pivot’ at the present time, will be when rate cuts finally materialise. Fed pivots (both expansionary and contractionary) over the last 20 years have resulted in significant downward movements in real yields as well as significant appreciation in the value of gold bullion and gold mining equities, for example:

• May 2000 to January 2008: gold bullion +234%, Gold Miners Index +508%
• January 2016 to August 2016: gold bullion +24%, Gold Miners Index +148%
• March 2020 to July 2020: gold bullion +30%, Gold Miners Index +110%

The US dollar is likely to be an additional tailwind under a ‘Fed pivot’ scenario on the basis that there has been a 0.8 correlation between the US dollar and real yields over the last 5-years.

Under this scenario, our outlook is for the gold price to strengthen to US$2,500-3,000/oz (+25-50%).

What about gold miners?

Gold mining companies provide natural leverage to the gold bullion price via their operating margin (which expands by more than the gold price when the gold price rises) and reserve ounces.

The index of gold mining stocks remains at valuations that we (and a number of other industry participants) believe is a 25-year discount to gold bullion (based on the spread between the spot gold price and the gold price implied by the market price of the equities).

T8 Gold is designed to deliver 1.5-2.5 beta to gold bullion (i.e. if the gold bullion price moves by one unit, we would expect T8 Gold to move by two units) through its concentrated exposure to gold mining companies.

We strongly believe that gold mining equity valuations at quarter-century lows combined with strong macroeconomic fundamentals for gold creates considerable asymmetry (considerably more upside than downside) in gold mining equities and T8 Gold.