Fast-rising interest rates have failed to cap gold’s record-breaking price run since 2022 as the spot price hit a record $US2798 an ounce on Friday to signal new forces are driving the precious metal’s stunning gains.
Between 1990 and 2022 the gold price tracked “real interest rates” defined as the risk-free rate on US government 10-year bonds minus the inflation rate.
In other words, “real interest rates” are positive when bond yields are higher than the rate of inflation.
This meant gold would rise in value as “real interest rates” fell, and fall in value as real interest rates climbed.
In effect, the more investors could earn a “real return” in income on risk-free assets the less likely they would be to bid gold higher.
The below chart shows the correlation, including how it decisively broke at the start of 2022.
So what’s behind the decoupling? Is it a structural shift? And what does it tell us about whether gold will extend a bull run that has propelled has propelled it 55 per cent higher from $1809 an ounce at the start of 2022 to $US2798 an ounce on Friday.
Ukraine conflict divides world
Some of Australia’s top macro-economists point to structural shifts in global markets investors should understand to get the big picture on gold’s price direction.
“[The split correlation] started with the Russia’s [February 2022] invasion of Ukraine that led to sanctions placed on Russian holdings in US dollars and other currencies,” says Shane Oliver the chief economist at AMP.
“So, other central banks thought that could happen to us and they thought maybe we should diversify away from the dollar into gold.”
Since Russia’s Ukraine invasion the European Union and US have confiscated $US282 billion ($412 billion) in Russian central bank assets, disconnected seven Russian banks from the SWIFT money transfer system, and sanctioned the assets of around 2,400 Russians.
“The US treasury used the plumbing of the financial system to exert additional pressure on Russia in early 2022 and major foreign investors have looked to gold as an alternative to US dollars,” said Matt Sherwood the chief investment strategist at Perpetual.
But what if there’s a ceasefire between Russia and Ukraine? Dr Oliver said that may only prove a short-term headwind for gold.
This is because it wouldn’t necessarily reverse (but rather slow) a widening divergence between countries allied to Russia and China across Africa, Asia, the Middle East and South America, versus those allied to Western nations led by the US.
At January’s World Economic Forum (WEF) in Davos worries over a split or fragmentation in the financial system were again top of mind for the world’s largest money managers.
“More and more, states seek to use the global financial system to advance geopolitical objectives,” said the WEF’s report on Navigating Global Financial System Fragmentation Risk.
“This poses a threat to the very integrity of the system and will have costs at a macroeconomic level as well as for financial institutions, ranging from asset stranding and valuation volatility to reduced liquidity and credit-rating risks.”
China’s gold rush
In particular, China’s central bank has cranked its pace of gold purchases since 2022 and bought more of the pet rock than any other central bank in 2023.
It finished 2024 with official holdings of 2,280 tonnes equal to 5.5 per cent of the world’s reserves, according to the World Gold Council (WGC).
A steep fall in Chinese government bond yields and a lurch into deflation have also encouraged record amounts of retail investors to buy gold exchange traded funds (ETFs) in China in 2024. Total assets under management in Chinese gold ETFs surged 150 per cent over the year, with $6.6 billion invested, according to the WGC.
In contrast to China’s deflation problem, the US has seen inflation driven by exceptionally high fiscal deficits as a percentage of gross domestic product, which reflects a government spending far more than it receives in tax receipts.
This widening budget deficits force the US government to issue more debt to finance its spending, which means bond investors are worried that more money printing will add to inflation as the dollar loses value.
In turn they’re demanding more compensation via higher yields that are a theoretical headwind for gold prices.
This week a surge in demand for physical gold by US investors has meant London’s Bank of England struggled to fulfill delivery orders with wait times ballooning to four weeks, according to widespread news report.
“Lots of governments used the pandemic as an excuse to run larger fiscal deficits,” said Mr Sherwood.
“So even though the US has had full employment since the end of 2021 it’s still running recession-type fiscal policy.”
Mr Sherwood added that the seemingly “permanent fiscal blowout” in the US is now pushing a metric known as “term premium” to its highest level since 2011.
In summary, term premium – as a measure of interest rate risk – rises as bond investors become more uncertain about future interest rate directions and fiscal policy, with the unknown policies of new US President Donald Trump encouraging investors to hedge their bets.
“And that is pushing bond yields higher and gold has moved in excess of that which shows gold is now being used by some global investors as a diversifier against the US dollar,” Mr Sherwood said.
“Trump’s trade policy is uncertain, but clearly inflationary, so you have a situation where investors can’t have any certainty about where inflation lands because no one knows Trump’s trade policy.
“The US equity market is also at its 98th percentile in terms of 12-month forward valuations relative to the past 20 years.
“So, that’s extremely expensive and big investors may see treasuries as a potential driver of risk, rather than a diversifier if US government bond yields continue to back up.”
Interest rate outlook
Mr Sherwood warns gold’s record run means factors other than growing demand for it as an asset class may still combine to tip it lower in 2025.
“The biggest challenge this year is bond yields,” he said. “My base case is the Fed’s finished easing rates this year and if not, they’ve only got one more cut in them.
“The Fed has the same problem as every central bank on inflation, as the only way they get to 2 per cent inflation is by crushing their economies.”
The final curve ball is the strong US dollar. It’s near a record high as measured by the DXY Index, which compares its value to a basket of six major currencies.
According to the economic textbooks, a reversal in US dollar strength should boost the price of gold and other commodities as they become cheaper for foreign investors to buy in base currencies.
Dr Oliver suggested some gold exposure may make sense for investors who want to diversify. “I wouldn’t hold a huge amount but within reason it’s worth thinking about,” he said.
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