The Gold Rally
Fund flows and mean reversion can explain price moves
By: Daniel Rasmussen
Gold prices have soared in 2024. Explaining why is difficult. It’s much easier to explain why a given stock price has gone up or down by looking at changes in earnings or forecast earnings. But gold doesn’t pay dividends and can’t be modeled with a discounted cash flow spreadsheet.
Investor Claude Erb and Duke University economist Campbell Harvey have been studying gold prices for years and have published a new study that seeks to puzzle through the rising price of gold and what it means for future returns.
Erb and Harvey argue that, over long periods of time, gold has maintained its purchasing power with a real return of zero. Their best example is that a Roman Centurion’s salary was roughly equal to a US Captain’s salary when priced in gold.
Although gold may be an excellent long-term hedge against inflation, the price of gold doesn’t move in lockstep with CPI data over short horizons. The price of gold appears far more volatile than the CPI.
Figure 1: 10Y Inflation Does Not Drive the 10Y Real or Nominal Return on Gold
Source: Erb and Harvey
The chart above shows that the correlation between short-term changes in inflation and gold prices is negligible, and so betting on the relationship is unlikely to make for a particularly good trading strategy.
Without the ability to easily explain gold price fluctuations with macroeconomic data, Erb and Harvey turn to explaining the price of gold by looking at buying and selling from major participants in the gold market. They find that gold’s price has a near-zero correlation with gold stock used in jewelry, owned by central banks, or in the form of bars and coins. But gold prices have historically had a whopping 0.74 correlation with the amount of gold owned by gold ETFs.
Erb and Harvey show that the price of gold has trended higher since the 2005 launch of gold ETFs.
Figure 2: Trends in the Real Price of Gold
Source: Erb and Harvey
But gold ETF buying doesn’t appear to explain the recent upsurge in gold prices. Gold ETF holdings peaked in 2020. So who is the incremental buyer driving price increases? Erb and Harvey think the Chinese central bank is the most likely culprit.
Figure 3: ETF Holdings and Chinese Bank Gold
Source: Erb and Harvey
It’s possible that China is attempting to use gold to create a challenger currency to the US dollar. Buying enough gold to do that would require purchases of such large amounts of gold that the price would have to move up substantially. And once the buying ended, the price would likely drop sharply. They argue therefore that establishing a new gold-backed currency would require overpaying by a large amount for the gold and incurring a substantial one-time cost.
As Erb and Harvey point out, high real gold prices tend to mean revert down.
Figure 4: High Real Gold Prices Associated with Low Future Gold Returns
Source: Erb and Harvey
With today’s real gold price at the high end of historical distribution, this research suggests gold could see a meaningful downward reversion in prices over the next 10 years.