Gold had a spectacular run from 2001 to 2011, rallying over 600% from $260 to $1,900 per ounce. Its performance since has been more modest, reaching $2,080 in July 2020, a level it struggled to maintain until it briefly broke out to a new high in December 2023.

Gold is often touted as an inflation hedge, but is that truly the case? Gold’s rally from 2001 to 2011 coincided with stable core inflation of around 2%. By contrast, from 2021 to 2023 when the U.S. economy experienced the steepest surge in inflation since the late 1970s and early 1980s, gold prices barely budged. So, if not inflation, what really drives gold? And what should investors expect in 2024 and 2025?

Gold is driven by both demand and supply factors. There are a few demand-side factors that drive the prices of gold on a day-to-day basis, and over the long term. They are the value of the U.S. dollar against foreign currencies, and the evolution of expectations for future Federal Reserve (Fed) policy. An additional demand factor is the buying of gold by central banks, which appears to move prices over the longer term. Finally, gold mining supply also has a strong influence on the price of gold, but one that is typically measured year to year rather than day to day. 

Central Banks as Buyers of Gold

Gold is the world’s oldest consistently used currency with close to 5,000 years of history. Admittedly, most people in 2024 might not think of gold as being a currency at all. It’s not in daily use, like in buying coffee, cars or homes. That said, the world’s central banks clearly view gold as a currency – or at least a reserve asset – and since the global financial crisis (GFC), they have been buying more and more of it (Figure 1). Many years of near-zero or even negative interest rates set by central banks combined with quantitative easing (QE) and various sanctions regimes led many central banks to favor gold over central-bank-issued currencies. Neither the recent uptrend in rates nor the reversal of QE appear to have assuaged those concerns.

Figure 1: After decades as net sellers, central banks became net buyers of gold after the financial crisis

The central banks’ post-GFC gold buying contrasts sharply with the time when central banks were net sellers of gold from 1982 to 2007. This implies that pre-GFC central bank policy entrusted fiat currencies like the U.S. dollar, euro, yen, pound and Swiss franc as reserve assets more than gold. This relationship reversed since the GFC. By all accounts, that tendency continued in 2023 despite central bank rate increases boosting returns on fiat currencies to their highest levels since 2007.

Central banks aren’t the only ones who tend to see gold as a currency. Strong and consistently negative correlations between gold and the Bloomberg Dollar Index (BBDXY) suggest that traders also see gold as an alternative to the U.S. dollar, not entirely unlike the currencies in Bloomberg’s Dollar Index such as the euro and yen (Figure 2).

Figure 2: Gold and silver have negative correlations to daily changes in the Bloomberg Dollar Index

What separates gold from central-bank-issued fiat currencies is that it pays no interest. As such, gold prices are typically averse to the prospects of higher rates. This, along with the strength of the U.S. dollar in 2021 and 2022, is likely what kept a lid on gold prices. Fixed-income markets went from expecting the Fed to keep rates on hold at zero for years in 2021 to accepting that the Fed needed to raise rates eventually to 5.375%. Since 2015, gold prices have almost always had a strong negative correlation with the daily change in Fed funds futures two years forward (Figure 3).

Figure 3: Gold averse to higher rates, correlates negatively with Fed fund futures

Despite gold’s failure to rally during the 2021-2023 surge in inflation, one could argue that gold is actually a pretty good inflation hedge, but it’s one that anticipates inflation rather than react to it. Between October 2018 and June 2020, Fed funds futures went from pricing Fed funds two years forward at 3% to nearly zero. During this time, gold prices rose from $1,200 to $2,080 per ounce, a 73% rally. However, when inflation arrived in 2021 and strengthened in 2022, it wasn’t great news for gold because it caused investors in short-term interest rates (STIRS) to re-evaluate their expectations for long-term Fed rates from 0% to 4.5%. So, while inflation may have lifted gold prices higher, the prospect (and later reality) of higher rates, pushed gold prices back down (Figure 4).

Figure 4: The prospect and reality of higher rates prevented gold from rallying from mid-2020-2023

What caused gold to perk up last December and briefly break out to a new record high were prospects for Fed rate cuts in 2024 and 2025. For it’s part, the Fed suggested in its “dot plot,” a sort of internal forecast among members of the Federal Open Market Committee (FOMC), that it was seeking to cut rates by 75 basis points (bps) in 2024. Fixed-income markets, however, are pricing for something much more dramatic, that is, for the Fed to cut rates by around 200 bps, with the first rate cut potentially coming as early as the Fed’s March meeting.

While a move towards such pricing may have helped gold recently, it may pose a challenge for investors in gold in the future. For rate cuts to benefit gold, they may have to exceed the 200 bps that Fed funds futures are already pricing (Figure 5), meaning the Fed may have to cut rates to below 3% by mid-2025 in order to keep the gold rally going.

Figure 5: U.S. interest rate futures price around 200 bps of Fed rate cuts over the next 18 months

Ultimately, how gold performs in 2024 and 2025 may depend on how the U.S. economy fares. A “soft landing” with minimal rate cuts along the lines of the 75 bps suggested by the Fed’s dot plot may prove bearish for gold. By contrast, an economic downturn accompanied by more rate cuts that currently expected might send gold to new record highs.

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All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.

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