As we covered in an earlier post, gold typically does well in two distinct scenarios:

1. Deep recessionary environments when investors rush to gold as a safe harbor in a storm.

2. Occasions where inflation is heading dramatically higher where even regular people flee to gold as a store of safe value.

You may have also noticed that today's macro environment bears very little resemblance to either of the above scenarios.

Inflation isn't rising and neither is the probability of a deep recession. In fact, as we have covered extensively, we think that instead the scenario that is rising in likelihood is a Goldilocks scenario of the "soft landing."

So what is going on? Does this signal that actually inflation could come roaring back? Or that a deep recession is imminent?

No.

There are four reasons gold is doing well right now:

1. The first is that central banks are buying lots of gold.

2. The second is that the US Dollar is falling in value.

3. The third is that gold is seen as a geopolitical hedge.

4. And the fourth and final reason that gold is doing well because real interest rates are falling.

The first catalyst for gold's rising value is perhaps the most complex:

Central banks - especially non Western central banks - are buying gold.

In general, central banks of any stripe want to hold assets that are safe and stable and yet, for a few reasons, many central banks around the globe have been busy diversifying away from traditional assets and especially US bonds.

This is especially the case for certain countries that are increasingly uninterested in holding large quantities of US assets - especially bonds. High inflation and high debt has consequences abroad as well as domestically.

Furthermore, m and more countries are falling out of the US-led international order. The postwar US-led trading and financial system is slowly fracturing because of geopolitical disagreement, sanctions, wars and trade conflicts. As a direct result of this many non-Western regimes are very wary of owning too many US assets. After all, our interests are no longer very aligned and, as demonstrated in the case of Russia, owning US assets can be an easily taken away as purchased.

This is having a predictable effect on the interest of some foreign central banks in holding US bonds. The challenge, however, is what else can you buy? Would you want to hold Russian bonds? Chinese bonds? Gold isn't just an obvious choice, it is also in some respects, the only safe choice. Many of these central banks are therefore replacing at least some of their US Treasuries with gold reserves.

This is a trend with a decent track record at this point. Last year, central banks purchased a record 1,136 tons of gold, according to the World Gold Council. There was another 800 tons bought in the first three quarters of 2023. We will likely end up close to the 2022 figure.

This is old fashioned approach to preserving wealth and a bit clunky (gold is after all, very heavy) but not necessarily a foolish strategy. True, gold doesn't yield anything but it can be sold very easily and no one can devalue it or easily take it away from you like an electronic bank transfer or an asset held overseas.

It likely won't shock you that China has been the biggest buyer of gold globally this year. The Middle Kingdom purchased 181 tons so far. That is a lot but gold is still only around 4% of their total reserves which means they have ample room to add if they want.

They almost certainly will. Would you want to hold the bonds of a country that was forbidding your industry from having access to certain high tech technologies?

The Chinese also won't be alone. India, Brazil, Russia, Saudi Arabia and plenty of other countries will almost certainly join them. This is a trend that should give the heavily indebted US pause. We won't hold our breathe.

The second reason gold has been rising in value is far easier to understand:

The US Dollar has been losing value.

Now that the US central bank has stopped raising interest rates and also there are, increasingly, expectations of interest rate cuts in the new year, the US Dollar has stopped appreciating in value.

Like a lot of assets, gold is priced in dollars so a falling USD means greater purchasing power for non-US based buyers. In today's world this is, of course, the vast majority of them.

To put this in context, the US Dollar index fell 3.5% in November. Gold therefore had a great month rising over 3.1% in that same time.

Third is the fact that gold is seen at a geopolitical hedge.

By hedge we mean that it can serve as protection from geopolitical events like wars, elections, referendums and terrorist attacks.

The reasons why investors want this protection are pretty obvious. As we approach 2024 there are a lot of investors trying to hedge against massive uncertainty. The war in Ukraine, war in the Middle East and also and especially, events like the US Presidential (and Congressional) elections that could heavily influence how these conflicts are prosecuted and resolved are front of mind for many investors.

But that isn't all. The risk of a wider war in the Middle East (or elsewhere!) is something we have discussed before. Just this past week the Iran-backed Houthis in Yemen have attacked US warships and commercial shipping in the Red Sea. The risk of a serious conflict continues to rise.

This is encouraging many investors to think conservatively, despite the strongly performing economy. Gold is the ultimate conservative investment. You buy the previous metal when you are very uncertain about what the future could hold.

Lastly, real interest rates are falling.

The US may not be entering a recession but thanks to falling inflation AND the US central bank's pause in raising interest rates, the real rate of interest in the US is falling.

This reversal matters. It makes certain assets more or less attractive.

A real interest rate is one that has been adjusted for inflation. So, you subtract whatever the inflation rate is from the current interest rates and you get the real one. The real rate of interest has been falling for two reasons.

1. The Fed has paused raising interest rates taking into account slowing inflation.

2. US economic growth is gently slowing.

This means that the expectations for the rate of interest you can get above inflation has peaked. This makes holding hunks of metal that yield nothing relatively more attractive especially considering the other uncertainties detailed above.

Okay but then, should you buy gold?

It is a tough call but we don't think so. It is true that gold could continue to rise from here driven higher by central bank buying in the new year as well as the geopolitical worries we have discussed at length.

BUT, in most of those scenarios other assets will do well or, more likely, quite a bit better. For instance, after a tough couple years, US bonds are now suddenly looking incredibly attractive especially in the scenario where we have a steep recession whether caused by war or not.

The one scenario that might really boost gold is a return of high inflation. That is possible and a risk we worried about a lot this summer and early autumn but we think it is reasonably low at least for the first half of 2024.

And don't feel bad if you missed out on the gold rally. Gold has returned just over 10% this year but the S&P 500 has returned over 20% in that same time period. Much like the Russell 2000 small cap index you would have to trade very nimbly and also be exceptionally clairvoyant to have nailed the very tight window of gold outperformance.

Still, you can watch gold to track which of the scenarios is unfolding. If gold continues to rise in 2024 then it is likely that either a recession or inflation is coming back strongly. Those are diametrically opposed events so it shouldn't be difficult to figure them out.

Until, keep an eye on the price of gold. It doesn't just glitter. It can tell you a lot about where we are headed.

Gold isn't the only asset to watch either. There are plenty of others to track.

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