Gold is a special category of assets with commodity attributes similar to bulk commodities, currency attributes similar to the US dollar, and financial attributes similar to bonds. As an investment product, gold also has the important functions of resisting inflation, avoiding risks, and asset allocation.
Commodity attribute Currency attribute Financial attribute
Gold has commodity attributes. Like other commodities, gold has certain utility functions. For example, thanks to the scarcity of production and its attractive golden luster, gold is made into exquisite jewelry to show the wealth and status of the owner; due to its corrosion resistance and strong conductivity, gold has become an ideal coating for electronic components. Metal has been recovered from discarded electronic products to make medals for the Tokyo Olympics. On average, about 1 gram of gold can be extracted from every 30 smartphones. In addition, gold is also widely used in aerospace, medical and other fields.
Gold has monetary properties. The “gold standard” was once a very popular monetary system arrangement. Although it has long since become a history, it still has many fans around the world. Gold has become their weapon against the excessive depreciation of their national currencies and to protect their own wealth. It should be pointed out that, at the public level, the monetary nature of gold is more of a simple belief of the people, and it cannot be directly used as a payment tool. In 1976, the IMF member countries reached the “Jamaica Agreement”, agreeing to cancel the official price of gold and promote the non-government of gold. Monetization; but at the central bank level, gold still retains a glimmer of its former glory and is one of the central bank’s reserve assets. At the end of 2022, gold accounted for 13.8% of the global central bank’s reserve assets.
Gold has financial properties. In addition to practical uses such as jewelry and gold-plated films for mobile phone circuits, gold, like stocks and bonds, is a widely recognized investment product, and there are many investment methods such as spot, futures, options, paper gold, and ETF. The global gold market has a large trading volume and strong liquidity. According to the World Gold Council, the average daily trading volume of gold in 2021 will reach 130.9 billion U.S. dollars, and the market depth is even close to that of U.S. Treasury bonds.
Anti-inflation safe-haven asset allocation
Gold is a hedge against inflation. Commodity attributes endow gold with the function of anti-inflation. Even if the currency is overissued on a large scale, the price of gold as a physical asset can “increase all boats”, thereby avoiding a significant depreciation of purchasing power. It is precisely because of the limited production of gold and its ability to resist inflation that the currency attribute of gold still has a broad mass base.
Gold can avoid risks. The safe-haven function of gold mainly comes from its “detached” characteristics. Gold is not attached to any country’s regime, and it is generally recognized around the world. Therefore, when a country breaks out of war or a crisis of sovereign debt, currency, exchange rate, etc., gold is the “safe” for residents of the country to protect their wealth. In addition, the role of gold in production and life is relatively limited, which makes its connection with the economic boom not as close as that of crude oil, stocks and other assets, thus becoming a “safe haven” for investors when the economy and financial markets fluctuate violently.
Gold helps with asset allocation. First, gold can bring long-term positive returns. Secondly, the correlation between gold and other assets is weak. Including gold in the investment portfolio can effectively diversify risks and improve the overall return-to-risk ratio.
Supply and demand analysis and pricing logic
As a commodity, the supply and demand situation of gold is naturally the basis for analyzing the price of gold. The World Gold Council publishes the supply and demand balance sheet of gold every quarter. However, gold is different from general commodities, and its financial attributes are stronger than its commodity attributes, so it has a relatively unique pricing logic.
The supply of gold includes mined gold, recycled gold, net hedging by producers, etc. Mineral gold is gold mined and refined from gold mines, and it is the main supply method of gold. Recycled gold is the gold formed by re-melting or refining the previous gold products. Most of them come from jewelry, and a small part comes from industrial products, gold bars and gold coins. Producer net hedging refers to mining companies hedging through derivatives such as futures, which can be understood as trading gold produced in the future in advance.
Demand for gold includes gold jewelry manufacturing, gold for technology, private investment, and central bank gold purchases. Gold jewelry manufacturing and technological use of gold reflect the commodity attributes of gold, while private investment and central bank gold purchases reflect the financial and monetary attributes of gold. It is worth noting that since the international financial crisis in 2008, global central banks have continued to increase their gold holdings, because the Federal Reserve and the European Central Bank started quantitative easing, and the attractiveness of the US dollar and the euro as foreign exchange reserves has dropped significantly.
Gold supply has relatively little impact on gold prices. First, the new supply of gold is relatively stable, and the output of mine-produced gold fluctuates less and its production areas are dispersed, making it less likely to form monopoly groups and supply shocks like crude oil. Second, unlike crude oil, gold will not be completely consumed, but will still exist in some form in the world. According to data from the International Gold Council, as of the end of 2022, humans have mined about 209,000 tons of gold, of which 46,500 tons are held by private investors, which is nearly 10 times the total supply of 4,754.5 tons of gold in 2022. This part of gold is potential supply power.
The financial attribute of gold is stronger than the commodity attribute, and the price of gold is dominated by investment demand. Gold investment demand comes from private investment and central bank gold purchases, and its volatility is significantly higher than that of gold jewelry manufacturing and technology use.
Real interest rate is the core pricing factor
Gold is generally considered a zero-coupon asset. Deposits, bonds, stocks and other financial assets will have returns such as interest and dividends, while gold, as a physical asset, is often just quietly stored in a vault without bearing interest.
Strictly speaking, gold can also obtain interest income through the leasing business. Within the agreed period, the lender will lend its own physical objects to the borrower at the beginning of the period, and the borrower will return the full amount of physical objects to the lender when it expires, and Pay the corresponding interest. But on the one hand, there will be counterparty risks after gold leasing, and the leasing interest rate is usually low; Investors cannot participate. Therefore, for most gold investments, gold is indeed a zero-interest asset.
The real interest rate is the opportunity cost of investing in gold. On the one hand, gold is a real asset and has the function of anti-inflation. The price of gold will rise as inflation rises, so inflation is the return of gold; on the other hand, gold is a zero-interest asset that will not carry Returns such as dividends, interest, etc., so the nominal interest rate is the implicit cost of gold. The nominal interest rate minus inflation is the real interest rate, which is the opportunity cost of gold. When real interest rates rise, the price of gold falls; when real interest rates fall, the price of gold rises.
The essence of gold is a supranational sovereign credit, interest-free inflation-protected bond. Supranational sovereign credit is because gold does not have any credit risk and has a hedging function; interest-free means that gold does not generate cash flow returns; inflation preservation is because gold has an anti-inflation function. The core pricing factor of this bond is the real interest rate, and its price is negatively correlated with the real interest rate.
The real interest rate is the core pricing factor of gold. There are two points to note:
First of all, the real interest rate here refers to the global real interest rate, because gold is an international investment product. However, in practical applications, the market usually uses the yield of the 10-year inflation-protected Treasury bond of the United States as a substitute. The United States is the world’s largest economy and has the largest financial market, and gold is denominated in US dollars.
Second, the real interest rate is equal to the nominal interest rate minus inflation, which is inflation expectations (the breakeven inflation rate of 10-year U.S. bonds), not actual inflation. From the perspective of asset pricing, the market trades expectations, so inflation expectations are more appropriate.
After mastering the real interest rate trend, we can make basic analysis and judgment on the gold price. The real interest rate mainly depends on the fundamentals of the U.S. economy, the policy stance of the Federal Reserve, and market expectations for the economy and policies.