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A Case For Gold

Updated: Apr 30, 2023

Inflation. That's been the trending word for the markets since 2021. Lot has been written about it recently and the case in favor of inflation, deflation or stagflation is still being fought by economists and analysts alike. Whichever wins the debate, we might have our own case ready to counter it. Through Gold.

Gold is a well known hedge against inflation apart from commodities. As fiat currencies lose purchasing power due to inflation, the value of gold increases in currency terms, hence a hedge against inflation. This is because Gold is a finite commodity that has been the medium of exchange before paper currency was invented. Gold was even backing paper currency until 1930, meaning currency was valued in-terms on Gold reserves that a country held. So there is a proven track record of Gold as an alternative currency that is finite, store of value and importantly tradeable. Everybody knows this, but why has Gold prices been increasing since the 2000s despite inflation going down for nearly 2 decades until 2021? Isn’t that against the general thesis that Gold is a hedge against inflation? Lets see how Gold prices correlates with Inflation over the last 60 years.

Inflation-Gold Correlation 60 Years
Inflation-Gold Correlation 60 Years

Source: MacroTrends

The above chart gives the correlation between Inflation & Gold since 1960. You can split the correlation into 2 distinct periods, Pre-2000 & Post-2000.

Until 2000, Gold clearly had a direct correlation with inflation. Inflation devalues the currency, meaning to buy the same product you bought for 100 dollars/rupees, you need to spend more than 100 due to inflation, so 100 dollars/rupees is worth less than 100. This is because, the central banks increased the amount of money available in the market, commonly known as Quantitative Easing(QE). QE and subsequent increase of M2 (Money supply) is a larger topic that we cannot cover in this article. But anyway, since 2000 until 2010, something has changed. Gold is no longer correlated to inflation. Inflation has either been falling or flat between 2000-2010, yet Gold has only rallied. So what changed?

Till 1999, major central banks around the world shunned Gold reserves and were emptying their vaults, this caused the Gold prices to plummet until 1999. But in 1999, the Washington Agreement was signed during the IMF annual meet in which it was agreed that gold should remain an important element of global monetary reserves and to limit their sales to at max 400 tonnes annually. This cap on sales from the monetary reserves, meant central banks cannot devalue Gold by selling it, effectively reaffirming Gold as an important asset. In fact, since 2021, central banks around the world have been accumulating gold for their reserves. Also, the investment thesis for Gold changed dramatically more favorable after 2000 for the below reasons.

  1. Most of the easy Gold deposits were already mined, making Gold more & more a scarce commodity. Also, it takes about 5 years from the discovery of new gold deposits to taking that gold out of the ground and to market. Any commodity which is not easy to find is a store of value and it's price appreciates.

  2. Gold transitioned from a commodity used for Jewellery & Industrial usage into a direct investment vehicle in terms of ETFs, Gold Funds & Digital Gold. With new investment avenues available and the increasing financial awareness of the public, Gold as an asset class benefited.

  3. Central banks around the globe through it's easing monetary policies, have injected liquidity to keep bond yields down in an attempt to spur growth. This has caused all asset prices to inflate. The dollar devaluation, high debt ratios of major economies, currency crises, inflation or even hyperinflation fears, has led to a favorable case for Gold as a hedge.

Now coming back to the inflation story, the devil is already out of the box. Inflation has picked up steadily but surely. Inflation is up due to confluence of pricing pressures. Supply & freight bottlenecks due to Covid lock-downs and higher crude oil prices has led to cost-push inflation. Though, the US Fed believes this to be transitory(back in 2021 at the time of writing this article), eventually they were proven wrong and inflation became the primary concern of the central banks. A sustained higher inflation is "conditionally" good for equity, but it's much much better for Gold. The late 1970s is a fair remainder for the correlation between S&P 500 (SPX) and Gold in an inflationary environment. SPX was up around 50% between 1976-1980. During the same period, Gold was up 700%. For the entire decade of 1970s, SPX was up 100%, but Gold was up a staggering 2000%!

Inflation-Gold Correlation 1970s
Inflation-Gold Correlation 1970s

Source: MacroTrends

In the 1970s, the US economy was coming out of a recession through monetary easing and low interest rates at the beginning. Easy money by the Fed, gave way to rising inflation which started at 2% in 1970 to hit above 11% by 1974. Inflation then normalised due to high base for the next 2 years, but began to come back ferociously between 1976-1980 where the inflation finally peaked at 14% in 1980!

Wait, I am not talking about the 2020s. If you can find some similarities, I can't help it. ;)

Back to the present, Central Banks' monetary policy and Govts' financial spending is working side by side tries to tackle a similar problem of 1970s, with a modified approach. The narrative is that, with Govt spending to complement the Fed, this overcomes the mismanagement of the past. But to discredit that narrative, debt has also been built up significantly by global economies to levels unseen in the past. Some market commentators argue that, it's just the same cookie in a different box. According to them, high debt levels could play spoilsport on the new MMT approach and the world is moving towards hyper-inflation. Even though equity could cope up with inflation, it's the creamiest of the companies with low debt that would hold up the index. All other highly leveraged large caps and many of the Mid & Small-Cap companies would be taken to the cleaners due to un-serviceable debts. If that's the future, then Gold is the best place to be in as an alternative to currency devaluation with more and more QE to boost growth and avoid a debt drisis.

But still, the inflation story is debatable and some market commentators expect inflation to be controlled, which would be negative for Gold. Alternatively, a case for deflation in various asset prices is also floated around. In a deflationary downturn in Equity, like March 2020, flight to safety from equity led to a Gold rally, since it is a natural hedge for equity. Such a deflationary market correction still needs a trigger, which is unknown at current juncture. Commodities which compliments Gold during an inflation, fails miserably during a deflation. Which leaves Gold and other precious metals the best fit for both cases.

Of Course, the downside is when we neither get higher inflation nor deflation. But given the history of how easy money have always led to runaway inflation, the possibility of it occurring again is quite high.

All that said, the article is never complete without looking at some technical charts.

Note: Below technical analysis was of June 2021 at the time of writing the article, and a future reading could mean that the events explained have already come to pass. At the time of writing in June 2021, Gold was trading at $1769, on Gold Futures on MXC at Rs. 46720 (10g).

The US Gold Futures weekly chart hints at a rally ahead with a distinct Cup & Handle pattern forming since 2016. The chart pattern is further strengthened by 2 more technical reasons.

Firstly, the formation of the handle near the high of the both ends of the cup. This indicates a consolidation around the zone of resistance. Had the price dropped strongly instead of consolidating, the entire formation would have looked like a double top. A double top can still form too, invalidating the C&H, but that's where the second technical support comes in. A 32 months long support trend-Line that has formed since late 2018 is acting as a cover for the handle. As the handle forms eventually, Gold could rally another 83% to reach around 3500 USD.

Why 83%? By general C&H theory, the breakout rally is equal to depth of the cup which was 83%.

Gold Future Long Term Chart
Gold Future Long Term Chart

Incidentally, the Fed's hawkish tone in the recently concluded meeting, led to a sharp recovery in the dollar index (DXY) and a fall in Gold and other commodities, last week. This is because the market is discounting the Fed rate hikes in 2023. But the devil is already out of the bottle and monetary decisions might not be so easy to take. Any change in interest rate regime carries the risk of a heavy correction on a frothy equity market. If that indeed happens, it's still good for Gold as a deflationary trade.

Regardless of how the market reacts to the Fed, we need to look at how Gold is set up to handle the news flow in the short term. From the bottom of the cup till the top, Gold has retraced to 0.382 Fibonacci Retracement level i.e.,1670 USD. It has bounced back from there marking the current low of the handle. Following last week's price reaction, Gold has again retraced back to -0.236 Fib Retracement level i.e., 1770 USD. A break of this level could lead to price trying to take support at 1670 USD again. That would essentially form a double bottom within the handle itself. A confirmation of the support at current level or the double bottom can then act as a positional entry. But if the low of the handle is broken, we might be forming a different pattern which has to be revisited later In such a case, the possibility of price dropping to 1444 USD level can't be ruled out. Beyond this level, the bull case of Gold has to be put aside until new evidence on the economy or the technical charts arise for a fresh bull case.

Gold Future Short Term Chart
Gold Future Short Term Chart

As closing comments, I need to draw attention to 2 things. Firstly, equity can rally along-side Gold. Equity Markets are on the verge of a possible euphoric melt-up for the reasons that I covered in my earlier posts. You can read them from the blog. This melt-up could inflate all asset classes in the final leg up of the bull market. Gold might lag the Equity markets initially, but as risk piles up, Gold could eventually catch up with Equity and even outperform as Equity tops out. Same should be said with other precious metals too. In a deflationary correction, Gold would also give up gains due to margin-calls and leverage. But Gold being considered as safety during uncertain times, might not fall as much as equity. Rather it could rally higher, if & when the inflation story plays itself out.

I must call out that hindsight analysis may or may not play out. That is why I tried to understand the reason for the change in Gold prices over decades to get more insight into the broader picture. Valid reasoning with data & combining them with technical set-ups is the right way forward and I hope I made justice to that. Despite the strong case for Gold, Central Banks around the world hold the whip in financial matters. Like the Washington Agreement of 1999, if the major Central Banks of the World feel a need to curb Gold's investment thesis, they can alter it's course like how they are going on with the QE spree. They have the power & right. So, as the case with any asset, this too need to be revisited often to check for validity.

Nevertheless, been a long post, but the current case for Gold is interesting and should be paid attention to. Interesting times ahead!

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