GLD: Central Bank Gold Demand Underpins The Gold Trade (NYSEARCA:GLD)

Gold has had quite a run as of late. The second leg of a bull run in gold, a run that began in early 2019 when the metal was trading at just over $1,200 per oz, seems to have gotten underway recently when bullion prices decisively broke through the $2,000 handle. Market speculation about an impending reversal of tight monetary policy and the presumed inflation that such a move would bring have been the cause of much market speculation.

Of course, the predominant narrative over recent years has been the “End of the Dollar Standard,” a tale that has periodically come and gone in some form or another since the establishment of the Bretton Woods System. In its most recent reboot, the theory posits that congressional gridlock, political polarization, and general economic malaise in the US will cause capital to flee to one of the other great powers, resulting in the value of their currency surging while that of the greenback craters. And since gold is priced in U.S. dollars, its value would climb substantially as that of the dollar fell.

In the telling of this little yarn, the US is typically characterized as completely inept while its geopolitical competitors are usually portrayed as shrewd and decisive with long and illustrious histories of economic decisions that are just shy of perfection.

Of course, the US government has taken many, many, many wrong turns over the years and economic growth rates have had their ups and downs; however, it’s worth remembering that the US has been the world’s largest economy and top superpower since 1945, so it must have done something right along the way. It should also be noted that even a casual perusal of the economic histories of the world’s other top economies will lead one to spot many, many, many poor and short-sighted decisions leading to tremendous inefficiencies and capital misallocation. So, while it’s true that the US does have its fair share of problems, so does everyone else.

The question then becomes: what does any of this have to do with gold; after all, isn’t gold a monetary instrument? And isn’t its value set relative to the valuations of other major currencies? The answer to those questions: Absolutely.

However, there’s also a case to be made that gold is used as a hedge on geopolitical risk and that rising tensions across the globe are resulting in a higher demand for bullion. And that’s the case that I’ll be making in this article.

An Extremely Abbreviated History

The 1980s was a turbulent time for gold prices. The start of the decade saw sky-high interest rates as Paul Volcker battled inflation, a fight he would win, and that resulted in gold losing much of the gains it had made in the late 1970s. The metal’s price eventually bottomed out in ‘85, the year the Plaza Accord was signed, and went on to have a brief resurgence in the lead-up to the crash of ‘87, but that was it. From then on until the early 2000s, the bullion trade was dead money.

There are many reasons as to why gold prices faded throughout the ’90s and early 2000s, but the primary cause relates to the collapse of the Soviet Union. The Soviet system was incapable of producing any type of manufactured goods that anyone would want to buy; therefore, when their system collapsed, the various countries that emerged from the USSR had to rely on the export of natural resources to balance their trade deficits in manufactured goods. They flooded global resource markets which had the effect of greatly reducing inflationary pressures around the globe.

These lower rates of inflation and the expectation of continued falling rates of inflation helped to push gold’s price lower. That was the monetary effect. The stability brought about by the US’ complete dominance of a global economic order with ample amounts of commodities and labor was the geopolitical side of the coin. Economic amplitude and geopolitical stability combined to push the price of gold to lows it hadn’t seen since the 1970s.

And by no means was gold the only major commodity to suffer price declines as a result of this turn of events. Most major commodities saw prices fall throughout the decade, oil had a brief surge at the start of the Iraq War, but for the remainder of the ’90s, it either traded sideways or downwards, and that was in spite of a booming US economy and strong US crude imports.

What eventually turned everything around, launching gold prices on a bull run that would last throughout the 2000s, was China joining the World Trade Organization. That event led China to become an export powerhouse and, in the process, soak up any excess supply to be found in global commodity markets, including gold. So, throughout most of the 2000s, gold prices experienced a bull run unseen since the 1970s; in fact, the 2000s price run even outpaced the gains from that earlier era.

Gold prices were impacted by the Great Financial Crisis of ’08-’09, getting knocked down about 25%, but the impact was short-lived, and before you knew it, prices were rising yet again. In many ways, the GFC added fuel to the fire as higher levels of systematic risk attracted many new investors to the gold trade and this new source of liquidity had the effect of pushing prices up even further. Looking at the chart below, one would think that the GFC’s impact on the gold market was brief, inconsequential, and forgettable. But that’s not the case at all.

As most readers are probably well aware, the GFC’s impact on broad economic thinking was substantial. One of its consequences was a reevaluation of the unquestioned deference many market participants had accorded the US Federal Reserve throughout much of the Volcker and Greenspan eras.

As mentioned above, the post-Cold War era saw the former Soviet Union become a major global commodity supplier, but that was by no means the only major change that occurred in the gold market during that period. Both the end of the Cold War and the GFC prompted changes of opinion by another major class of market participants in the bullion market.

Central Banks

The peace of the post-Cold War period, falling inflation, and shrinking US budget deficits caused central banks to reevaluate the role of gold as a reserve instrument, and many took the decision to reduce their overall gold holdings. And as the chart below listing net central bank purchases shows, this resulted in them becoming net gold sellers for most of the next two decades. In fact, the selling only accelerated throughout the late ’90s and continued right into the middle of the 2000s.

Perhaps unsurprisingly, this trend began to drastically change with the onset of the GFC. Within the span of a few short years, net central bank gold selling, which had reached levels in excess of 500 tonnes per year, quickly turned into net central bank gold buying in excess of 500 tonnes per year.

However, it should be noted that this was not the result of any change in the geopolitical arena. The US-led post-Cold War global order was still very much intact as relations between the US, China, and Russia were good; what had changed, however, was faith in the global financial system. Both these points are evidenced by the fact that in 2009, the US government felt the need to dispatch the Secretary of State to China in order to reassure the Chinese government and Chinese central bank on the soundness of U.S. debt.

At the time, unease concerning the global banking system was widespread, and central banks were not the only actors to increase their gold purchases. As can be seen in the chart below, the years following the GFC also saw investors purchase a lot more physical gold. And unsurprisingly, these increased purchases of physical, coupled with net buying from central banks, pushed bullion prices ever higher.

But all good things must come to an end, and as fear eventually subsided, bar and coin purchases fell back to lower levels, and so did the price of bullion. And once again, gold was dead money for years to come. Nevertheless, under the surface, things were astir.

The Great Game

The never-ending shifts in global economic and military power meant it was inevitable that the post-Cold War order would eventually fracture. And as the 2010s progressed, it became increasingly evident that the US-China détente that had been architected by Kissinger in the early ’70s was not long for this world. The relationship between the two quickly began to cool under the Trump administration and that trend has continued under Biden. Tariffs on some goods went up, some microchip exports were banned, and the Taiwan question has gained renewed importance. However, the two countries still do a lot of business together and relations between them have not deteriorated to levels anywhere near those of US-Soviet relations during the Cold War.

A change of at least equal significance, if not greater, that has occurred over the last decade, has been the ramp-up in US crude oil and natural gas production resulting from the implementation of new drilling technology. This has transformed the US from one of the world’s largest energy importers to being a net energy exporter. It is a change that is quite substantial and far-reaching.

The world is currently awash in crude, so much so that nominal prices remain well below their levels of ten years ago. And those are nominal prices that don’t take into account the increased cost of extraction. The cost of oil platforms, tankers, pipelines, oil worker salaries, etcetera, have all been subject to at least the same rates of inflation as all the other goods in the economy.

For the broadly diversified American economy, that’s not much of a problem, but for countries that are almost wholly dependent on revenue generated through the export of hydrocarbons, which is a very serious matter. The response of some nations, such as Saudi Arabia, has been to invest in the development of new industries in the hopes of creating new sources of revenue. The impact on others, such as Russia and Iran, has been to become more aggressive and warlike in attempts to destabilize the post-Cold War peace.

Now, this is not to suggest that lower energy prices have been the sole cause of the Russia-Ukraine war and recent conflicts in the Middle East. Obviously, these are complex and multifaceted issues about which books have been written. However, it’s highly likely that tightening revenue constraints on authoritarian regimes will elicit a reaction. So, it’s reasonable to presume that energy prices do factor into the strategic decision-making processes of large hydrocarbon producers, especially those that have no other industries upon which they can rely to generate export revenue.

The Gold Market

The impact of the post-Cold War order’s destabilization on the gold market has been swift and readily apparent. For most of the last decade, total gold demand oscillated between 4,000 and 4,500 tonnes annually, the exceptions being the pandemic year of 2020 and the previously discussed years of 2011 to 2013. Granted, the composition of that demand has varied as amounts required for jewelry fabrication waxed and waned and demand from investment products such as ETFs rose and fell; however, aggregate levels of demand remained within a tight range.

But as can be seen in the chart above, demand broke out of that range in 2022, and the breakout was entirely due to increased volumes from central bank purchases. Now, granted, most central banks rarely provide explanations as to why they choose to increase their gold allocation, but it’s worth remembering that 2022 was the year the Russo-Ukrainian war broke out. And while it’s true that it has recently faded from the headlines, it is still very much an ongoing conflict. As global geopolitical hotspots multiplied over the course of 2022 and 2023, central banks kept up their elevated rates of gold purchases.

The only major class of market participants that has been leaning against the trend has been gold ETF investors. Their net selling in 2021, 2022, and 2023 has kept the price of gold contained; however, if central bank purchases remain at elevated levels within the foreseeable future, it is not hard to imagine investors reevaluating their bearish thesis in the face of these constant central bank liquidity flows into the bullion market.

And if that occurs, we could see gold experience some significant upside over the next couple of years. Investors could see another $500 to $600 per oz price rally, akin to the price move witnessed in the 2019-2020 price surge.

GLD

I currently own gold but not through SPDR Gold Shares (NYSEARCA:GLD); however, if I were initiating a gold position today and I chose to go the ETF route, GLD would be at the top of my list. The fund is benchmarked to physical and is the largest gold ETF on the market, it has also been an industry standard for many years now. The fund charges a very reasonable 0.4% annual expense ratio and millions of units are traded daily. It’s a solid product and provides investors the opportunity to gain exposure to price changes in bullion.

Risks

Investing in commodities is inherently risky, and investing in gold in anticipation of continued strong central bank bullion purchases is even riskier. Central bankers do change their minds and have gone from being net gold purchasers to net gold sellers in the past and could very well do so again. Also, there is certainly no guarantee that investors will stop selling gold and begin to be net buyers. There is always the risk that gold ETF outflows not only continue but accelerate in the coming months and years. If that were to occur, ETF selling could very easily overwhelm central bank purchases and cause gold prices to fall precipitously.

Takeaway

The thesis of gold as a monetary instrument is widely known and often discussed; however, the metal’s role as a hedge on geopolitical risk is something that is far less talked about. The fundamental changes currently occurring in global energy markets are bringing about deep structural change in the world’s geopolitical order and the reaction of central bankers has been to increase their gold allocations. If this trend continues, which seems likely, it could lead to substantial appreciation in the price of gold.