Bi-Weekly Asset Allocation – The Gold Paradox


Confluence Investment Management offers a variety of asset allocation products that are managed using top down or macro analysis. We publish asset allocation thoughts every two weeks, updating the report every other Monday, along with a podcast.

Gold prices have been weak in recent months despite high levels of inflation. Gold is often seen as a hedge against inflation, and so the lack of strength is confusing to many investors. In this report, we will take a look at gold and try to explain why prices have failed to recover from rising inflation.

We begin our analysis of gold using our basic price model, which uses the balance sheets of the Federal Reserve and the European Central Bank, the USD/USD exchange rate, the real two-year Treasury yield and the budget deficit. We also have a variant that adds bitcoin.

Spot gold prices have underperformed the model for the past two years, but in the most recent update, the standard model’s fair value estimate has fallen closer to current prices. This would suggest that the market was anticipating a weakening of positive fundamentals. As the Federal Reserve shrinks its balance sheet and two-year real yields rise, in line with dollar strength, we expect further weakness.

But what about the issue of inflation? Isn’t gold a hedge against inflation? Not really. Rather, it is a hedge against currency depreciation. In classical economics, inflation and currency depreciation were essentially the same thing. The classic model assumed full employment of resources (due to price and wage flexibility) and stable velocity; thus, the only source of inflation was excessive money supply. However, the model was flawed. Not only do prices and wages lack flexibility, which means idle resources can exist, but velocity is far from stable. So, even with a stable money supply, inflation can occur if velocity increases or supply shortages develop.

Instead, the best way to think of gold is that it is a currency independent of government and debt. Most of the currencies we use are backed by liabilities; for example, the “money” used in deploying a credit card is money created by a bank liability. Currency depreciation is difficult to determine. If the money supply increases due to increased bank lending, for example, is this a decline or a reflection of investment demand? As a result, markets tend to rely on exchange rates to determine depreciation. It is not a perfect solution1, but it has the advantage of clarity. The impact of the dollar on gold can be seen in the chart below.

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Bi-Weekly Asset Allocation - The Gold Paradox

In this chart, we are deflating gold prices by CPI and index that level to January 1970. We then compare that to the JP Morgan dollar index, which adjusts the dollar for relative trade and inflation. Periods of gold strength tend to coincide with periods of dollar weakness. Note that in the 1970s, when gold developed its reputation as a hedge against inflation, the dollar weakened considerably. The rise of the dollar during the Volcker years led to lower gold prices, as did the period of dollar strength from 1998 to 2022. In fact, you could say that gold is holding up quite well against the strength dollars; in previous periods, when the dollar index was this high, gold traded much lower. The reason gold is doing relatively well is likely due to the factors discussed in the first chart. Expanded central bank balance sheets and negative real interest rates have supported gold, but a bull market in gold will likely require dollar weakness.

1 If all central banks pursue expansionary monetary policies, then exchange rates reflect relative decline, as opposed to absolute decline.

Past performance is not indicative of future results. The information provided in this report is for educational and illustrative purposes only and should not be construed as individualized investment advice or a recommendation. The investment or strategy discussed may not be suitable for all investors. Investors should make their own decisions based on their specific investment objectives and financial situation. The opinions expressed are current as of the date indicated and are subject to change.

This report was prepared by Confluence Investment Management SARL and reflects the current opinion of the authors. It is based on sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change. This is not a solicitation or an offer to buy or sell securities.


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