Economic explanations for gold’s sharp fall

In the weekly Buttonwood blog published in the previous week’s edition of The Economist on April 20, the topic was the plunge of gold earlier this month. We agree that it is hard to find convincing economic explanations for the sharp fall. However, Buttonwood is wrong in some of the conclusions about economic developments and the price of gold.

The Economist states rightly that not only gold, but commodity prices in general had been falling year-to-date. Crude oil prices also were down by mid-April, but WTI is trading again at the level of the start of this year, while Brent is still down 8.3% YTD despite the recent recovery. Also some base metals reached multi-year lows earlier this month. Especially copper, which is often dubbed the metal with a PhD. in economics and regarded as a bellwether for the global economic development, is not reflecting forecasts of a rebounding world economy. Also grain prices have come down compared with the level prevailing at the end of the harvest season in the Northern hemisphere last year. The development of commodity prices is certainly not underlining the optimism, which had led to a shift from gold into equities being observed during the first quarter. However, the decline of prices for Brent oil and the grains has an impact on headline CPI inflation rates because they are usually highly weighted in consumer price indices. Thus, the decline of commodity prices has reduced the risk of rising headline inflation despite the aggressive monetary easing by major central banks, which increased their balance sheets substantially over the last couple of years.

Buttonwood argues further “… if economic sentiment were improving significantly you would expect investors to sell government bonds as well as gold. Here Buttonwood errs. If the global economy would expand strongly, then the demand for commodities would also increase. One reason for the weaker oil prices were the downward revisions for oil demand by OPEC, EIA and IEA due to slower than previously expected global growth. Thus, an increase of headline inflation would have to be expected. In addition, Japan targets now a CPI inflation rate of 2% over the next two years to overcome the depression. Also the Fed forecasts that the extremely lower interest rates will prevail until around mid-2015. Thus, in major economies, monetary policy remains highly accommodative. Furthermore, the risk would increase that the balance sheet extensions would lead to increasing lending to the private sector and that also core inflation would edge up if global growth accelerates. Therefore, one would expect that gold would be bought and bonds would be sold if economic sentiment were improving significantly. Thus, the phenomenon observed since mid-March that bond yields declined and gold dropped just reflects that short-term inflation risks have declined, which is also mirrored in the development of inflation expectations measured by the spread between nominal and inflation-linked US Treasury paper.

The Fed clearly stated conditions under which QE would be stopped. These conditions are not negative for gold because either inflation has to rise above a threshold or the unemployment rate has to drop to a target level. The first case is obviously positive for gold as it would be bought as a hedge against increasing inflation rates. But also the case of terminating QE on unemployment rate falling to 6% would be positive for gold as it requires stronger economic growth and would lead to higher wages, which one would expect to translate into higher core inflation.

Buttonwood argues further that gold were hard to value because of not having a yield or earnings. Certainly, gold has no earnings. But this is also the case with many companies, especially start-ups, which even produce losses during the first few years. Nevertheless, the stock market prices the equities of those companies, once they are publicly listed. Also for bonds with a fixed nominal coupon, the market has to find a fair yield to reflect the fundamentals. Negative real yields on 10yr notes, as it is the case for US Treasuries or German Bunds are certainly not a fair value for investors.

For gold, as for any other good, marginal production costs are one yardstick for longer-term pricing. However, quantitative methods also allow the development of various fair value models. Whether those models are based on traditional ordinary least square (OLS) methods or vector autoregressive (VAR) methods, they provide a fair value for the price of gold. Also volatility models, which include fundamental factors for explaining the return on gold and its volatility (GARCH-X models), could be applied. They all show that there are three major factors play a role for explaining the price moves of gold. These factors are the stock market, the price of crude oil and the US dollar index. While the US dollar index and the oil price were negative for gold, the stock market – represented by the S&P 500 index – was positive. However, the two negative factors were not sufficient to explain the plunge of gold and other precious metals in mid-April.