Updated: Feb 20, 2022
Gold market is a cyclical market. Prices experience bull and bear cycles with each cycle lasting on average about two years over the last decade. Gold price is an indicator of true economic health given its close correlation with macroeconomic factors such as M2 Money Supply, inflation, Treasury Inflation Protected (“TIPS”) rate, the dollar index and the precious metal demand and supply among others. Usually gold prices remain high during economic downturn and at time of crisis and decline during economic upturn. With investors trading dollar when the dollar is strong and trading gold given a weak dollar, the demand for gold as a safe haven asset increases during recessionary environments such as COVID-19 or 2008 financial crisis. The demand for gold is also driven by its use in jewelry, manufacturing and electronics with India, China and the US among the larger consumers. The following graph displays historical gold prices as well as day over day gold returns. In order to determine a rough estimate for gold cycles, the difference between spot prices and the 10-year average gold prices are plotted in the second graph. XAU= is the data item for gold spot prices that is sourced from Refinitiv.
Looking at historical gold prices over the last 10 years, the descriptive statistics and distribution of gold prices are displayed below. Given the histogram of gold price, gold has a lognormal distribution with a mean price of $1,363 and median price of $1,303 per ounce.
Given the drivers of gold price, as displayed below, there is an inverse relationship between the price of gold and TIPS rate (-81% correlation). TIPS rate is a proxy for inflation adjusted cost of borrowing to purchase gold and store it. Gold is also a hedge against inflation. Hence when the yields are falling, gold prices tend to rise. The yield tends to fall when the economy is getting weaker and rise when the economy gets stronger. Other important drivers are US M2 Money Supply and dollar strength. There is a strong positive relationship between price of gold and M2 Money Supply (87% correlation) and a negative relationship between price of gold and dollar strength, represented by US Dollar Index (.DYX). As inflation is caused by an increase in Money Supply and given that gold is a hedge against inflation, money supply growth positively impacts the price of gold, causing it to increase during economic upturn.
In order to forecast gold prices and present an outlook, Modelyze Investments regressed gold prices relative to M2 Money Supply, and US 10 YR TIPS rate. Given the strong correlation between gold price and its macroeconomic drivers, this linear regression has a very high R2 of 80%. Based on the linear regression coefficients and historical M2 Money Supply and TIPS rates, predicted gold prices and under or overvaluation of gold are determined by comparing the predicted prices with the actuals. When the predicted gold price is above the actual gold price, gold price continues to climb and when the predicted gold price is below the actual gold price, gold price declines. Predicted and actual historical gold prices are displayed in the following graph.
https://fred.stlouisfed.org/series/M2 and Refinitiv