The increasingly complex geopolitical and financial environment makes gold reserve management more relevant than ever before. Trump's inauguration doesn't seem like the final chapter, it's more like a prelude. As the possibility of increasing tariffs globally from a "campaign agenda" gradually becomes a reality, the baseline assumptions are the continuation of de dollarization and geopolitical changes, and the probability of a short-term shift in central bank attitudes towards gold reserves is relatively low. As the most important driving force of this round of gold bull market, there is currently no sign of reversal or even weakening, and gold should continue to maintain a bullish mindset.
As expected in our report at the beginning of the year, gold has continued its bull market from the fourth quarter of 2022 to the present (see "Can Gold Prices Achieve a New High in 2024?", February 29, 2024). The year-on-year increase in gold prices during the year once exceeded 45%, and the last time gold prices experienced such a significant rise was during the quantitative easing period of the Federal Reserve in 2011.
Recently, catalyzed by the settling of the dust from the US election, gold fell 5.3% in 7 trading days, including election week, setting a record decline since March 2022 (7 trading days up and down). Therefore, the market is beginning to worry whether the bull market for gold is over.
To answer this question, we first need to clarify the main driving forces behind this bull market in gold. We judged at the beginning of this bull market that the replenishment of central bank gold reserves was the main increase in demand, and this has gradually been verified in the past two years.
In our report "How is Gold Priced?" (January 21, 2023), we mentioned that the two factor model of real interest rates and VIX has historically had a strong explanatory power for gold prices, but it failed in 2022 because the central bank's gold reserves reached a new high, supporting the trend of gold prices.
The two factor model composed of Vix and real interest rates reflects that gold is a risk averse asset in the short term and a shadow of currency in commodities in the medium term. The model ignores the long-term pricing scale of gold prices, representing deep concerns about the global credit currency system.
We use the annual increase in central bank gold reserves as a proxy for this long-term concern, and reconstruct a two factor gold price fitting model for real interest rates and central bank gold reserves on an annual frequency basis (as it is an annual data, VIX is not considered as a short-term pricing scale). The results showed that the new two factor model can also explain more than 80% of the fluctuations in gold prices, and both explanatory variables are also very significant (P value is 0).
In the history from the subprime crisis to 2021, the general direction of real interest rates has been downward, while the central bank's gold reserves have increased, both of which have a positive driving force on gold prices. It was not until 2022 that the driving force of real interest rates on gold prices deviated from reality, and the market realized that changes in central bank gold reserves may also be an important pricing factor for gold prices. The explanatory power of real interest rates on gold prices may have been overestimated—— The Ultra Long Cycle of Gold - Gold Pricing Series Report II "(March 22, 2023)
The quarterly data on gold reserves released by the World Gold Council this year has declined compared to the same period last year. The cumulative increase in central bank reserves in the first three quarters decreased by 17% year-on-year, with a decrease of 140 tons. At the same time, as the country with the largest increase in gold reserves purchased in 2023, the People's Bank of China suspended its holdings from May this year and resumed buying in November. This has led to a widespread belief in the market that the central bank's purchase of gold has slowed down since the middle of the year.
On the other hand, another factor in the model - the 10-year US Treasury real interest rate, has also fluctuated upwards since the beginning of this year, rising from 1.72% at the end of last year to the current 2.07% (as of November 22). Both factors seem to have a negative impact on the gold price, but it has risen from $2063 at the end of last year to $2632.66 currently. Does this mean that there are any driving factors that have not been captured by the model?
Let's first discuss the real interest rate with stronger data availability. Our model introduces the real interest rate as a pricing factor mainly based on its characterization of financial properties. In our report at the beginning of the year (see "Can Gold Prices Set a New High in 2024?", February 29, 2024), we mentioned that the current financial attributes mainly drive institutional investment behavior. This year, the scale of gold ETF products has continued the downward trend of last year, indicating that institutional investment demand is still weakening. This is consistent with the slight deterioration trend of financial properties this year, but the ETF size has decreased by 163 tons compared to last year. We believe that this is because this year, in addition to financial attributes, some investment institutions have reduced their holdings of gold due to the risk aversion caused by geopolitical factors such as this year's election. This demand has weakened after the election but has now stabilized, and subsequent changes will depend on the geopolitical situation.
Another factor is the central bank's purchase, which has always had the problem of low data frequency and low quality (see "Can the 2024 gold price still reach a new high?", February 29, 2024). In fact, it is quite difficult to judge changes in reserves solely by observing the central bank's balance sheet. It can be said that the changes in gold holdings on the central bank's balance sheet are only a part of reserves: taking the data from the World Gold Council as an example, the comprehensive increase in central bank gold reserves of 162 countries and regions announced on a monthly basis in 2023 was only 361.4 tons, while under the annual data caliber, the global national reserves increased by 1049.1 tons. The difference of 688 tons in between is the reserve changes that are not displayed in the monthly announced central bank balance sheet.
So where can we obtain official demand that is not listed on the high-frequency central bank balance sheet? In fact, we can get a glimpse of it in the quarterly balance sheet of the World Gold Council. In the first three quarters of this year, the sub item with the highest increase in demand was OTC and Other, which increased by 190 tons compared to the first three quarters of last year. According to the database definition of the World Gold Council, this number is used to balance the supply and demand balance sheet, and can be understood as the "residual term" after subtracting explicit demand (household demand+central bank purchases) from gold supply. Although the central bank's purchases in the first three quarters of this year are 140 tons less than last year, the total demand unrelated to residents (investment+consumption+industrial use) has increased by 50 tons this year.