Is it a golden era for gold?

Executive summary

• The price of gold is often driven by a complex interplay of factors, including the U.S. dollar exchange rate, real yields, supply/demand dynamics and sentiment. In recent years gold has exhibited a tendency to react to real yields in an asymmetric manner, supported by strong central bank purchases.
• We are constructive on gold given peaked real yields, elevated geopolitical uncertainties, robust central bank demand, and anticipation of more retail participation.
• For long term investors, gold merits a position in a diversified portfolio, potentially serving as short-term protection against risk events, a reliable longer-term store of value, and most importantly as a portfolio risk diversifier.

Gold has been a sought-after commodity for centuries, and a popular component in investment portfolios in modern times. The metal has historically delivered attractive long-term returns, appreciating ~8% on an annual basis over the past 20 years. That said, its price has exhibited significant volatility – with prices tumbling around 40% from 2011 to 2015, before it fully recovered in 2020. Since late 2023, the metal has experienced a strong rally, consistently reaching new all-time highs. At the time of writing¹, gold has narrowly outperformed the S&P 500, ranking as one of the best-performing assets in 2024.

Into 2025, we retain a bullish view on the metal, with an outlook of it reaching $3,150/oz by the end of year.² The price of gold is influenced by a complex interplay of macro factors as well as supply/demand dynamics. Understanding its unique characteristics and benefits is crucial for investors who look to establish portfolios that endure through cycles. This article aims to identify and analyze the key drivers of gold prices, how they evolved in recent years, and how an appropriately sized gold investment can add value to a portfolio from an asset allocation perspective.

What drives gold prices?

1. The level of the U.S. dollar

Historically, gold prices have often exhibited a negative correlation with the value of the U.S. dollar, as gold is denominated in dollars. When the USD weakens, gold becomes relatively cheaper for holders of other currencies, thereby increasing demand. Conversely, gold prices tend to weaken as the dollar strengthens. However, there are instances when this relationship does not hold. For example, in 2012-13, gold lost 18% of its value even though the USD remained relatively stable, rising less than 1%.

Looking ahead, we think the dollar environment remains largely benign for gold prices. Following a significant rally after the U.S. election results, the current level of the dollar reflects heightened expectations regarding inflation and the Federal Reserve's terminal rates. The threshold for a substantial further repricing screens high. From a fair value perspective, the dollar is currently trading 10-15% above its fair value implied by interest rate differentials and its long-term average. Over the longer term, dollar is likely to ultimately mean revert and unwind its overvaluation. This reversion process may take some time, as the dollar could be temporarily supported by cyclical growth outperformance in the U.S. compared to other major economies. However, we expect any additional strengthening from current levels to be limited. Overall, this outlook suggests a relatively stable environment for gold prices into 2025.

2. Change in real yields

Historically, gold prices have demonstrated periods of an inverse relationship with real yields (i.e. inflation adjusted interest rates). As gold itself does not generate interest income, real yields can be seen as the opportunity cost of holding it. When real yields go down, gold becomes more attractive relative to interest bearing assets such as cash and fixed income securities. This inverse relationship explains a large part of the price increase in gold since the 1990s, as real yields progressed lower, down a path of structural decline. Large gold rallies such as those from 2008-2012 and 2019-2021 can also be attributed to real yields falling into negative territory, as global quantitative easing and Zero interest rate policies severely depressed yields.

However, over the past two years there has been a notable divergence between movements of gold prices and real interest rates. In early 2022, the Federal Reserve embarked on an aggressive tightening cycle at an unprecedented pace, under the backdrop of stubbornly elevated inflation and exacerbated global supply disruptions following the outbreak of the Russia-Ukraine war. Real yields rose aggressively from deeply negative territory to the highest levels seen since the Global Financial Crisis of 2008. 10-year U.S. real yields rose by a historic 250bps over the course of 2022, followed by another 20bps rise in 2023. In this environment gold prices remained very resilient. Prices were mostly unchanged in 2022, although with significant volatility, and in 2023 posted a +13% return, ending the year at a record high of $2,068/oz. 

Has the correlation permanently broken? We believe it has temporarily shifted, and will likely reestablish itself at some point. We find that for now, gold still reacts to the movements in real yields, only in an asymmetric manner – it declines less when rates go up and rises more when rates move down. Why? The answer to that is largely related to a recent shift in supply and demand dynamics.

3. Supply and demand dynamics

All commodities, at their core, are driven by supply and demand. The price of gold is affected by other drivers, as discussed above, but supply and demand are a key factor. Global mining of gold has been fairly stable for many years, and so the demand profile is particularly important and unique. This sets it apart from other commodities. There are several key sources of demand for gold, which can be categorized into three groups: industrial, investment and reserve management.

Industrial demand

• Jewelry fabrication. Jewelry demand accounts for around 50% of total annual gold consumption. As a beauty, permanence and status symbol, gold is highly coveted with demand particularly strong in Asia, especially from India and China.
• Technology. Around 10% of gold demand comes from industrial and technology uses, in industries including electronics, dentistry, aerospace and others.
  
  

Investment and Reserve Management 

While investment and reserve management demand accounts for a smaller portion of total gold consumption, they can periodically be a more significant driver of gold prices. The impact of reserve managers or Central Banks has been more evident in recent years.

• Central banks

Central banks have been significant buyers of gold for decades. In the 19th Century most countries fixed the value of their currencies to gold, and this became known as the Gold Standard. Central banks were required to hold sufficient gold reserves to back their currencies and allow convertibility of currency into gold. This system was highly disciplined, but proved to be unworkable during times of crisis. Eventually governments found the need to expand monetary supply beyond the restrictions of the gold standard, and the system was abandoned after the Second World War to be replaced with the Bretton Woods System. This system fixed the dollar to gold at a set price and fixed international currencies to the dollar. Unsurprisingly this too proved to be unworkable, and as the United States began to run large deficits, strains began to emerge. Eventually the U.S. fully abandoned the link to gold in 1971, leading to the collapse of Bretton Woods. This allowed the price of gold to float freely on international markets.

Although the need to hold gold as a reserve asset was now removed, the scarcity of gold inherently made it appealing to Central Banks as a store of value. This role has waxed and waned over the years, but as can be seen in the chart below – over the past 20 years, central banks worldwide now keep around 20% of their Foreign Exchange reserves in gold. That said, there is a significant variance between DM and EM central banks regarding gold allocations, with emerging market holding much lower than their DM peers.

After a long hiatus, central bank purchases have risen notably in recent years. According to statistics compiled by the World Gold Council, net purchases by central banks around the world reached a record 1,082 tonnes in 2022, more than doubling the average annual purchase over the previous 10 years. This strong purchase momentum continued in 2023, maintaining a breakneck pace of 1,037 tonnes. The first three quarters of 2024 saw purchases of 693 tonnes, matching the pace of 2022 despite a sharp price rally. After pausing for a few months, China’s central bank (one of the biggest gold buyers since 2021) has resumed purchases in November. This is now acknowledged to be a main driver of gold price resilience during the recent rise in real yields.

The outlook of central bank purchase remains strong into 2025, as over 80% of global monetary authorities expressing willingness to increase gold holdings, as suggested by a recent World Gold Council survey (see chart below). There are various reasons for central bank increases in the accumulation of gold. However, it has become apparent that in some cases, nations that are not allied with the United States have begun to look to reduce their reserve mix away from dollars, as they perceive the risks of keeping these reserves vulnerable to sanctions. Other governments aim to add some protection against higher and more volatile inflation worldwide, as the developed world exits the era of ultra-low inflation post-GFC. The scarcity of gold sometimes allows it to play a role as an inflation hedge, although this is often transitory.

• Retail and institutional investors

Many investors hold positions in gold as part of an investment portfolio. These investments can be made via exchange-traded funds (ETFs), futures markets, options, or structured notes. Many investors prefer to hold the physical metal – and invest in bars, coins and claims linked to individually-numbered bars.

Holdings of gold ETFs have become more popular with retail investors since their inception in 2004 and hit a record in 2020 when the Covid pandemic caused worldwide lockdowns. Since then, holdings have been on a gradual decline, and now are back to pre-pandemic levels. Retail ETF flows in gold are often seen to be driven by fears of inflation, conflict or crisis, and the relative level of interest rates. These investors tend to be short term, but can be effective drivers of price. Institutional investors are more long term and often hold the metal physically. Pension funds and Foundations, in particular, tend to hold the metal for decades.

Hedge Funds and Commodity Trading Advisers are more speculative in their approach, but can have prolonged impacts to price movements.

Our outlook on gold

We maintain a constructive outlook on gold over the next 12 months. The demand outlook remains robust, with strong central bank purchases likely to continue. We also anticipate increased inflows from retail investors in the coming year, driven by declining cash rates. Despite some uncertainties surrounding the inflation outlook, the Federal Reserve is likely to continue reducing the policy rate from its currently highly restrictive levels. The prospect of lower returns from cash investments could prompt retail investors to rebalance their portfolios in favor of gold, a segment that has been largely absent from the rally over the past two years. As evidence of this trend, ETF holdings have begun to rise since May/June, roughly coinciding with the decline in cash yields. That said, retail investors have only increased their holdings by 4% through ETF purchases, leading us to believe that the gold trade is far from being a crowded position.

Additionally, we expect gold to perform well under a Trump administration for two primary reasons: 1) ongoing concerns about the U.S. deficit, as fiscal policy is likely to be expansionary, and 2) a potential increase in USD reserve diversification amid trade tensions and rising geopolitical risks. Our current outlook projects gold prices to reach $2,900 to $3,000 by mid-year and $3,100 to $3,200 by year-end.

Gold in a portfolio

The best possible reason to own gold in our view is as a diversifier in a portfolio. This was perfectly illustrated in 2022 as global equity markets lost -19.46%, global bonds lost -16% and Gold rose 3%.  The diversification benefits are amplified when viewed through the lens of modern portfolio theory, which holds that diversifying across lowly-correlated assets can improve overall risk-adjusted returns. Historically, gold has exhibited a low, or sometimes negative correlation to traditional asset classes, such as equities and bonds. In our view, having gold as a part of your asset allocation makes sense as a portfolio ballast that helps to enhance the risk-return profile.

¹Data is as of December 9, 2024.

²Outlook estimate represents the midpoint of the range of $3,100 – $3,200.