This has been a remarkable year for gold so far. Prices rallied in the spring, setting new records and trading above $2,600 per ounce for the first time.
What makes this rally so remarkable is the fact that it was not underpinned by the drivers which have been dominating the gold market for more than a decade: the US dollar, US bond yields and western world investment demand.
These factors have been absent for most of this year as the dollar stayed strong and bond yields high, keeping western investors out of the gold market as they were finding more attractive alternatives in high-grade sovereign bonds.
Instead, gold demand was dominated by emerging economies, most notably China. Investors returned to the gold market amid the pronounced weakness of the domestic economy in general and the all-important property market in particular.
Real estate has traditionally been the preferred asset in China, but falling property prices have kept investors away. Gold became the asset of choice for Chinese investors seeking a safe haven.
The same holds true for the People’s Bank of China. While it has been increasing its gold reserves for many years, buying accelerated following Russia’s invasion of Ukraine and the subsequent seizure of the Bank of Russia’s US dollar assets by the United States.
This has prompted China's central bank to become less dependent on the US dollar as a reserve asset and – in an extreme case – less susceptible to US sanctions.
According to our calculations at Julius Baer, China’s gold reserves are up almost 800 tonnes since the start of 2022, of which around 40 per cent was officially reported by the People’s Bank of China. The remainder is estimated based on exports from the UK to China, which were not recorded as imports, however.
According to the International Monetary Fund’s guidelines, monetary gold does not need to be recorded in official trade statistics.
Somewhat surprisingly, the People’s Bank of China has not reported any additions to its gold reserves since this April, while imports from the UK have also dried up during the summer.
While this has caused some concern in the gold market, the banking regulator has paused its gold purchases in the past.
We believe the big picture still calls for an increase of its gold reserves.
Firstly, the geopolitical tensions between China and the US are unlikely to disappear anytime soon, independent of the outcome of the US presidential elections. China’s desire to diversify its US dollar exposure should thus persist.
Secondly, despite its large-scale buying, China’s share of gold in its currency reserves remains at less than 5 per cent. This compares to a global average of more than 15 per cent and still leaves significant upside when measured on a tonnes-of-gold basis.
As China has been absent from the gold market for the past few months, the focus has returned to the US and bullion's ties to the US dollar and US bond yields have strengthened again.
Fears of a US recession have resurfaced while the country's Federal Reserve has begun interest rate cuts. As a result, western world safe haven seekers have started to tentatively return to the gold market, supporting prices around record levels.
While the logic of lower interest rates and higher gold prices seems clear at first sight, a closer look at all interest rate-cutting cycles since 1975 reveals that this relationship only holds if the US economy slips into recession.
In such cases, gold was up around 15 per cent on average one year after the first interest rate cut. If the US economy did not slip into recession, however, prices were down 7 per cent on average.
Looking ahead, the gold market is set against a very interesting backdrop, which can be summarised by the question: “Who is willing to pay more – western world safe haven seekers or the People’s Bank of China?”
As we do not see the US economy slipping into a recession and as we expect the tensions between China and the West to persist, we believe the Chinese central bank’s willingness to pay for gold as a hedge is much higher – not least because its motivation to add gold to its reserves is political, not economical.
Therefore, central bank gold buying should return as the dominant driver of the gold market, with western world investment demand primarily representing an upside risk.
Carsten Menke is head of next generation research at Julius Baer
