Original Cheng Shi, Xu Jie FT Chinese 2024-04-25
Looking ahead, it is expected that real interest rates may continue to fall, and the hedging effect of the superposition and the continuous increase of gold reserves by many central banks will enhance the attractiveness of gold.
Text丨Cheng Shi, Xu Jie
Gold has always been seen as a safe-haven asset, especially in times of economic turmoil, as the saying goes, "gold in troubled times". However, this seemingly unchanging "common sense" does not actually apply in all periods. This paper analyzes asset prices and economic data over the past 30 years, and uses a time-varying coefficient model to re-examine the relationship between gold and economic performance, inflation expectations and the risk environment.
The study finds that the price of gold has three main characteristics: first, from the perspective of asset allocation, the value of gold is universal, and there is a solid negative correlation with the US dollar index and real interest rates. Second, gold's effectiveness as a hedging tool has limitations, and traditional "common sense" can only be verified when policy uncertainty is high, inflation expectations are high, and market volatility is high. Therefore, although gold has some hedging value, a variety of factors limit its function as a safe-haven asset. Finally, in recent years, the gold price has seen a decline in both its stable negative correlation with the US dollar index and real interest rates, as well as its non-linear relationship with policy uncertainty, inflation expectations and market volatility.
Looking ahead, it is expected that real interest rates may continue to fall, and the hedging effect of the superposition and the continuous increase of gold reserves by many central banks will enhance the attractiveness of gold. Although the Fed's pause in interest rate cuts has led to a phased rise in the dollar index, gold's fundamentals remain solid in the medium to long term.
The value of gold as an asset allocation
Gold has always been an important element in global asset allocation, especially its relatively stable negative correlation with real interest rates and the US dollar, which became particularly evident after the 2008 financial crisis, highlighting gold's high sensitivity to economic variables.
First, the negative correlation between gold and the US dollar is key to understanding its investment value. The U.S. dollar, as the main currency for international transactions and reserves, has a profound impact on global financial markets. Typically, a strong US dollar makes gold less attractive, as investors are more inclined to hold US dollar assets with higher returns and lower risk. Conversely, when the US dollar depreciates, investors tend to turn to gold as a store of value and an investment option. An analysis of the price data from 1990 to 2024 based on the time-varying coefficient model shows that there is a significant negative correlation between gold and the US dollar index most of the time. This negative correlation is even more pronounced especially during periods of significant volatility in the US dollar index, such as the 2008 global financial crisis and subsequent years. During this period, increased global economic uncertainty prompted international investors and central banks to increase their holdings of gold to hedge against the volatility of the US dollar and maintain asset values.
Second, there is also a degree of negative correlation between gold and real interest rates. The real interest rate, which is the nominal interest rate minus the inflation rate, is an important measure of investment returns. In an environment of low real interest rates, the opportunity cost of holding gold, a non-interest-bearing asset, is lower, adding to gold's appeal. However, empirical data show that before the 2008 financial crisis, gold's relationship with real interest rates was not significant, and even showed a significant positive correlation between 2006 and 2007. However, the 2008 financial crisis was a turning point, with monetary easing by central banks around the world to stimulate the economy, causing real interest rates to fall into negative territory. Since then, the negative correlation between gold and real interest rates has become more stable and significant. This relationship changed again as the Fed began to raise interest rates gradually and adjusted real interest rates to positive territory. As real interest rates rise, the opportunity cost of holding gold increases, which is reflected in the increased volatility of gold prices and the weakening of the negative correlation with real interest rates. In addition, as other investment channels, such as the stock market, have picked up, investor flows have begun to change, further weakening the theoretical negative correlation between gold and real interest rates.
Figure 1: The time-varying relationship between gold and the U.S. dollar index
Source: Bloomberg, ICBC International Computing
Figure 2: The time-varying relationship between gold and real interest rates
Source: Bloomberg, ICBC International Computing
Limitations of gold as a hedging tool
The results of the analysis of the time-varying coefficient model reveal the relationship between gold and a number of economic variables, which do not show a fixed universal pattern. On the contrary, gold's investment "common sense" only shows its effectiveness in specific economic scenarios, especially in an environment of "high uncertainty", "high inflation expectations" and "high market volatility".
From the perspective of hedging policy uncertainty, gold's performance has shown significant differences over time. For example, during the 2008 financial crisis and the 2011 European debt crisis, the regression coefficient of gold was positive and the absolute value was large, indicating that the price of gold showed a significant upward trend during the period of rising policy uncertainty, which is consistent with its attributes as a safe-haven asset. However, in other periods, such as 2001 and 2014, the regression coefficient was close to zero or negative, indicating that gold prices did not respond strongly to policy uncertainty or even had an inverse relationship.
From the perspective of hedging inflation expectations, the relationship between gold and inflation is also more complex. During the 2008 global financial crisis and the subsequent economic recovery phase, there appeared to be a strong positive correlation between gold's regression coefficient and inflation expectations, suggesting that gold typically rises in price as a hedge when inflation expectations rise. However, at other times, gold's sensitivity to inflation expectations may be weakened by a more gradual change in inflation expectations or by other factors.
Finally, from a hedging against market volatility, the relationship between gold and stock market volatility is not always negatively correlated. In fact, the regression coefficient is sometimes negative or close to zero, suggesting that gold is less sensitive to market panic during certain periods. It is only when market volatility is high, such as during the 2008 financial crisis, that gold's hedging relationship becomes apparent. These analyses show that while gold is often seen as a safe-haven asset, its effectiveness as a hedging tool is influenced by a variety of economic variables, which work differently over time and in different economic environments.
Figure 3: Gold's time-varying relationship to policy uncertainty
Source: Bloomberg, EPU and ICBC International calculations (Note: The GEPU Index is an average of a GDP-weighted national economic policy uncertainty index covering 21 countries: Australia, Brazil, Canada, Chile, China, Colombia, France, Germany, Greece, India, Ireland, Italy, Japan, Mexico, the Netherlands, Russia, South Korea, Spain, Sweden, the United Kingdom, and the United States.) ）
Figure 4: Gold's Time-Varying Relationship with U.S. Inflation Expectations
Source: Bloomberg, ICBC International Computing
Figure 5: Gold's time-varying relationship to market volatility
Source: Bloomberg, ICBC International Computing
In recent years, gold's allocation attributes and hedging utility have weakened
Since 2022, the absolute reversion coefficient between the gold price and related variables, whether they are related to the US dollar index and real interest rates, or the more volatile relationship between policy uncertainty, inflation expectations and market volatility, has been lower than the historical average, according to the results of the time-varying coefficient model. This change means that traditional asset correlations are weakening, and asset price movements are starting to show some different patterns than in the past, such as the recent global rally in risky and risk-free assets. Therefore, in the short term, it will be more difficult to explain the trend of gold prices in theoretical asset relationships, and the volatility of gold prices may be further complicated.
Looking ahead, real interest rates are expected to continue their downward trend, which will provide support for gold prices. The decline in real interest rates reduces the opportunity cost of holding non-interest-bearing assets, increasing the attractiveness of gold as a store of value. While there may be a phased rise in the dollar index, it is likely to be temporary, given that the US is likely to reassess its monetary policy. If the dollar strengthens, while it may weigh on gold in the short term, gold's fundamentals remain solid in the medium to long term.
From a hedging perspective, gold, as a traditional safe-haven asset, is particularly important during periods of heightened market volatility. The current global political and economic uncertainties, such as trade protectionism and geopolitical tensions, may prompt investors to seek more stable investment options. In this environment, gold can provide a certain sense of security, especially when traditional risky assets such as equities show high volatility. In addition, the trend of central banks in countries including China, Russia, and India continuing to increase their gold reserves has further strengthened gold's position as a reserve asset. These central banks buy gold in order to diversify their foreign exchange reserves and enhance economic security, especially during times of global economic turmoil. This continued demand not only reflects the widespread recognition of gold's value, but also provides continued support for the gold price. As a result, despite changing market conditions and economic trends, gold is still seen as an important investment and reserve option, providing stability and security during uncertain economic times.
Figure 6: Changes in gold reserves in the world, China, and Russia (tonnes)
Source: iFinD, ICBC International
The views expressed in this article are solely those of the author
Cheng Shi is the chief economist of ICBC International, and Xu Jie is a macroeconomic analyst at ICBC International
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Image courtesy of Getty Images, author provided