The price of gold hit a record high in sterling terms last week, of just under £1,200 an ounce. This reminds us of both the case for holding the metal and the dangers in doing so.
By far the most important driver of the gold price is the yield on government bonds. There’s a simple reason for this. Gold doesn’t pay interest. Which means that when yields are high gold is unattractive because we are giving up lots of income when we hold it. As bond yields and interest rates fall, therefore, gold becomes more attractive because the cost of holding it falls. Which means its price rises. It is for this reason that there has been a huge correlation between five-year gilt yields and the sterling price of gold – of 0.91 in monthly data since 1995. (This isn’t to say that investors regard only gilts as the alternative to gold. The point is that they compare global bond yields generally, but these are highly correlated with gilt yields.)
Herein lies a big reason for gold’s latest rise. Because yields have fallen, so gold has risen.
This is not the only reason for the metal’s recent rise, though. Gold’s price is also positively correlated with the dividend yield on the All-Share index – a link that holds even controlling for gilt yields. This tells us that gold is in part a safe-haven asset; it does well when equity valuations fall. With equities having been hit by fears that the coronavirus epidemic would hit China’s economy, it is natural therefore that gold should rise.
In fact, the impact on gold of equity and bond yields is so strong that they offset another driver – commodity prices. Gold is positively correlated with these. Controlling for changes in equity and bond yields since 1995 a 10 per cent rise in the S&P/GS index has tended on average to raise gold’s sterling price by just under 3 per cent.
Other things being equal, therefore, the recent drop in commodity prices caused by fears for China’s economy should have depressed gold. But other things are rarely equal. When commodity prices fall, bond yields sometimes fall too and equity yields rise – and for the same reason, fears for the global economy. Because the impact of lower gilt yields is stronger than that of commodity prices, we sometimes see gold rise when other commodity prices fall.
Which leads to an important and under-rated point. It’s often said that gold protects us against inflation. This is both true and false.
It’s true in the sense that over the long term gold has risen while consumer prices have risen, and so holding gold has preserved our purchasing power. The long term here is very long. Emperor Augustus (who reigned from 27BC to 46AD) paid his centurions 38.6 ounces of gold a year. That’s equivalent to just over £46,000 – which is the salary of a captain in the British army now. Gold has thus kept pace with nominal wages over the past 2,000 years.
But it is false in another sense. Gold does not protect us from near-term variations in inflation expectations. In fact, if we measure these by the difference between index-linked and conventional gilt yields, they have moved in the opposite direction to gold. The metal often does well when inflation expectations fall, and badly when they rise. The fact that gold has hit a record high at a time when inflation expectations have fallen (and actual UK consumer price index inflation has hit a three-year low) thus fits the historic pattern.
Let’s put this another way. Imagine that the world economy were to strengthen sufficiently to raise inflation. What would this do to gold? On the one hand, the metal would benefit from rising commodity prices generally. But, on the other, gilt yields and share prices would rise, which would tend to depress gold. And the history of the past 25 years warns us that the latter effect would dominate.
There’s a simple message here. There’s a reason to hold gold. And it is not that it protects us from inflation. Instead, it protects us from recession or secular stagnation – from anything that reduces bond yields and share prices.
Such protection, however, comes at a price. If gilt yields were to rise, gold might fall even if commodity prices and inflation expectations rise.
For anybody with a reasonably balanced portfolio, however, this is not a great problem as these are circumstances in which share prices would rise sufficiently to offset losses on moderate holdings of gold.
In this sense, gold is a form of insurance. No less. And no more.
