PHILIP SHORT: Will gold continue to edge out treasuries as a safe haven?

The gold price remains on a record-breaking run as we head towards the unpredictable US elections, buoyed by its historical and increasingly attractive 21st-century geopolitical and macroeconomic attributes.

But will it continue to rally even though it falls short as an investment in some respects, including not generating income and thus imposing an investment opportunity cost when real rates are positive? The breakdown of the relationship between gold and the US 10-year real rate since the Russia-Ukraine war started suggests so.

Gold has always been seen as a safe haven asset, a store of value and something universally appreciated. Out of the 118 elements on the periodic table, its unique atomic qualities make it fit for this purpose. It’s solid (not a gas or liquid), noncorrosive, nonradioactive, noncombustible, malleable, rare and shiny. This is why, almost by a process of elimination when working through the periodic table, it has been desirable as a means of international exchange for the past 5,000 years.

Not everyone finds it desirable though. Many investors have raised an important concern: how do you value it? And if you can’t value it, how do you know what price to pay? Perhaps if one looks at it from a relative point of view, understanding its value becomes more agreeable.

From a relative point of view, what would you own instead? Looking towards the lower end of the risk spectrum of assets, how about money in an interest-bearing bank account or owning US treasuries? The latter asset is based on a strong, global reserve currency and backed by the world’s strongest, biggest economy, so these assets arguably have equally desirable qualities.

Historically, gold has been strongly correlated with negative real rates — when interest rates, adjusted for inflation, go down, gold increases in value. The reason is that gold does not earn an income or pay a dividend, and there is thus an opportunity cost to owning it when real rates are positive. Instead of owning gold, you could earn interest in an almost risk-free money market account. However, that relationship changed when the Russian-Ukraine war started in early 2022, as can be seen in the graph.

Debt default

As a consequence of the war, and as “punishment”, the US and its allies froze all Russia’s foreign reserves, including US debt held by Russia (debt and interest payments owed to Russia by the US). The US is now considering whether it should give this Russian money to Ukraine to assist it in its war efforts. Moral issues aside, you cannot disavow a debt. 

Given the enormous debt the US government has built up, now sitting at $35-trillion, some have questioned whether the US will default on its debt. Given that all US debt is in dollars, it can simply print what it owes, so it shouldn’t default. (The effects on the worth of the dollar if that happens is a story for another day.) So the US is able to pay its debts. But is it willing? In the case of the US freezing Russia’s holdings of US debt, it is unwilling to do so. And if you’re unwilling, it’s as good as being unable.

Now imagine being China on the sidelines, watching the US not honouring its debt to Russia. As China, would you be buying more US debt, or would you be selling your current US debt holdings, especially if you already have a tense relationship with the US and have your own regional intentions regarding Taiwan?

China, once the largest holder of US debt after the Federal Reserve, has been reducing its holdings since at least 2018 and even more aggressively since 2022, at the beginning of the Russian-Ukraine war. And so have some of its Brics allies. Given that some countries are selling what they once considered a safe haven asset, what other safe haven asset is there to buy? Gold — and lots of it.

Driving forces

Since the Russian-Ukrainian war, central banks worldwide have been buying far more gold. Beginning in the first quarter of 2022 this spree coincided with the dislocation of the relationship between gold and real rates. The chart shows the strong demand that followed in the second to fourth quarters of 2022 and continues now. This is the main reason for gold’s strong performance. 

Where to from here? The two scenarios discussed above — real rates and the US decision to weaponise its debt — are expected to be the main driving forces behind the movement in gold: 

• Real rates are determined by nominal interest rates minus inflation. The combination of lower US interest rates and higher inflation results in lower real rates, which should continue to affect gold. If real rates come down faster than the market expects, gold will go up, all else being equal. And vice versa. The market is now expecting the Fed to begin cutting in September, so watch that space if you own gold. Also, keep an eye on US inflation. 
• Has the US crossed the Rubicon by freezing Russia’s US debt assets? If a newly elected US president walks back on freezing Russia’s foreign reserves, will the market take it to mean it will never do so again? Maybe initially, but my guess is that the proverbial river has been crossed. 

Gold’s current upward trajectory highlights that for some gold has replaced US treasuries as a core, safe and internationally recognised asset to hold. At times when inflation is greater than interest rates — meaning your money is losing value in real terms if sitting in a bank account — gold’s appeal will become even shinier. Geopolitical instability adds to its global appeal.

• Short is fund manager at Flagship Asset Management.