Gold, monetary policy and the US dollar

14 October 2020

After briefly exceeding USD2,000 per ounce in August, the price of gold has retreated more recently, prompting some commentators to wonder whether the rally that started in 2018 has come to an end. In this Macro Flash Note, GianLuigi Mandruzzato looks at the drivers of the price of gold and concludes that it will be supported by extremely accommodative economic policies and expectations of a weak dollar in the coming years. Historically, the price of gold has risen to compensate for the loss of value of the US dollar.

Gold price set to rise further
The performance of the gold price has been exceptional so far this year. It has risen by more than 26% at the time of writing this note, rivalling the tech-heavy Nasdaq index. This follows a period of strong performance in the second half of 2018 and last year: since August 2018 the price of gold has risen by 59%, marginally outpacing the total return on Nasdaq of 54% (see Chart 1). 

Chart 1. Gold price and Nasdaq total return (1.8.18=100)

Source: Refinitiv and EFGAM calculations. Data as at 09.10.2020.

The sharp rise in the price of gold is unusual for an asset considered defensive and appreciated for its low volatility, especially over a period in which risky assets such as equities have also performed well. Indeed, when the price reached a record USD2060 per ounce in early August, the risk of overvaluation was clear. For example, the August peak was outside the 67% confidence range of the projection from a simple econometric model (see Chart 2).1 The subsequent correction has brought the price inside that confidence range, suggesting that it is now more closely aligned with its fundamentals.

Chart 2. Gold price back in line with fundamentals

Source: Refinitiv and EFGAM calculations. Data as at 09.10.2020.

The relevant question for investors is whether the uptrend will reassert itself. This depends on the behaviour of the variables in the model, which are themselves uncertain. A VAR model considers the interaction between the gold price, the yield on 10-year Treasury bonds, the US dollar trade weighted index and the Vix and the uncertainty about their future behaviour.2 It is therefore possible to project the future gold price and the confidence range around it (see Chart 3). The result indicates that the upward trend of the price of gold can continue in 2021, even if the speed of the rise will be more moderate than in the last two years.

Chart 3. Gold price forecast (VAR model based)

Source: Refinitiv and EFGAM calculations. Data as at 09.10.2020.

The macroeconomic context favours the yellow metal
This result is consistent with two macroeconomic factors: the ultra-expansive economic policies mix which will persist for some time and the expected weakness of the US dollar. Although it has not explicitly committed to such a policy, the Federal Reserve does not expect to raise the federal funds rate before 2023. This will keep Treasury bond yields low even in the face of the Fed's hoped-for increase in inflation and the large public budget deficits needed to overcome the shock of the Covid19 pandemic. Unlike government bonds gold does not pay a coupon, so the low level of Treasury bond yields reduces the opportunity cost of holding gold as a safe asset within a diversified portfolio, increasing its attractiveness. It not surprising that inflows into gold ETFs have been strong of late (see Chart 4).

Chart 4. Global net inflows into gold ETFs (USD bn)

Source: World Gold Council and EFGAM calculations. Data as at 09.10.2020.

According to the model, the price of gold moves in opposite direction and roughly equal size to the US dollar index. The long-term fundamentals of the US dollar, including Purchasing Power Parity, signal the risk of depreciation of the greenback against the major currencies. If this were to happen, the price of gold in US dollar would rise to compensate for the loss of value of the US dollar.

One factor that could, at least temporarily, support the US dollar is the possible election of Joe Biden as President of the United States. This follows from the observation that Trump has been negative for the US dollar, despite official rhetoric highlighting its excessive strength. In fact, if the yield differential between the US and the eurozone is considered, one would have expected the US dollar to have been significantly stronger against the euro over the last four years than it actually was (see Chart 5).

Chart 5. Trump was negative for the dollar

Source: Refinitiv and EFGAM calculations. Data as at 09.10.2020.

Conversely, coinciding with Trump's inauguration as president in January 2017, the dollar began to depreciate against the euro. In the spring of 2018, the EUR/USD exchange rate reached 1.25 and then gradually declined until the spring of 2020. Biden's election could therefore provide temporary support for the US dollar, perhaps reflecting the expectation of a more diplomatic attitude from the US Administration towards China and other international partners, not least the European Union.

In conclusion, the rise in the price of gold is set to continue, albeit at a less exuberant pace than in the last two years. The expectation of very expansionary monetary and fiscal policies for some more time and the fragility of the dollar are the main factors supporting the outlook for gold price.


1  Over the period January 2004 – February 2020, the monthly change in the price of gold is estimated as a function of of 10 year US government bond yields, the nominal US dollar trade weighted index against developed economies and the Vix index of implied volatility of options on the S&P500 equity index. The conditional forecast of the gold price from March to October 2020 is based on the realised values of the exogenous variables and can be compared to the actual gold price to evaluate it against the fundamentals.For more details on the econometric model, see the Infocus “Is there a new gold rush?" published in July 2019.

2  The VAR model of the monthly changes of the four variables is estimated with two lags on the period January 1999 – October 2020. The unconditional forecast of the price of gold spans from November 2020 to December 2021.