Just seven months ago, gold hit a record intra-day high of $2,075 per ounce. Finally, the yellow metal had managed to significantly exceed its old record of around $1,900 from September 2011. This rally came when higher inflation was expected, as governments around the world announced stimulus measures to address the economic devastation wrought by the coronavirus pandemic. In addition, there were record-low interest rates, more bond purchase programmes announced by developed world central banks, and the US dollar’s decline.

The Dollar Index, which measures the greenback against a weighted basket of currencies, fell around 12% between March and August last year before levelling out. Yet gold has fallen around 18% from its record high, currently languishing just a touch above $1,700 per ounce.

What impacts the price of gold?

The common rule of thumb is that the price of gold (in dollars) moves inversely to the US dollar. The thinking behind this is that if the dollar goes up in value, gold becomes more expensive to buy for non-dollar holders. While simple and neat, this is also incorrect. There have been plenty of times where this relationship has broken down. Likewise, it’s often said that gold is inversely correlated to equities. However, a quick glance at the charts from March 2020 or the financial crisis of 2008/9 will show you that theory doesn’t always hold either.

Two other widely-accepted maxims are that gold always does well during periods of high, or rising, inflation, and does badly when interest rates increase. The explanation for the former is that investors seek out hard assets, like gold, to protect themselves from currency depreciation. As for the latter, gold generally doesn’t pay interest (unless you’re a bullion bank) so isn’t especially appealing compared to the financial instruments that do. There is some truth in both these propositions, but really it’s the combination that matters.

Gold and inflation

Investors naturally look for ways to protect themselves against inflation, but they also expect central banks to raise interest rates to keep inflation under control. While gold looks like an attractive hedge against rising prices, this isn’t the case when interest rates are going up too. However, it’s the real interest rates that matter — that is, the interest rates adjusted for inflation. In other words, when inflation kicks in but central banks hold off from raising rates in response. When investors see this happening, gold then becomes an attractive investment proposition.

Now we’re seeing evidence of a rise in inflation in many commodities, such as copper and nickel, and agricultural produce too. Little of this has been picked up in the major inflation indices such as the Consumer Price Index (CPI) or the Personal Consumption Expenditures Price Index (PCE) —  the US Federal Reserve’s preferred inflation measure. The last PCE update showed an increase of 1.5% from the same period last year, which is still a fair degree below the Federal Reserve’s official 2% target rate. Not only that, but the Fed has announced that it’s happy to let inflation rise above this level for some time before halting its bond-buying programme, let alone raising its key Fed Funds interest rate.

What does this mean for gold?

All this suggests that we’re approaching a positive environment for gold as it’s the real rates that matter — bond yields minus inflation. We’ve lived with a zero, or even negative, interest rate policy for years now and inflation pressures have been subdued. Yet with a growing perception that inflation is picking up, even if it isn’t showing up in the official data, there could be a change in sentiment. This is especially likely given that central banks are unwilling to raise rates.

That said, there is a catch. It’s now arguable that gold is no longer the go-to safe-haven it once was thanks to the growing popularity of an alternative: Bitcoin. The cryptocurrency shares many of gold’s qualities, such as limited availability, but has an advantage in that it can be used as a medium of exchange.

Sure, there are still issues concerning Bitcoin’s take-up and security, which means gold may remain popular as a safe asset. The next bout of serious inflation, twinned with low interest rates, will show us whether gold has finally been usurped as the ultimate haven for investors, or whether Bitcoin must wait a bit longer for its day in the sun.

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