Gold is generally known as the number one safe haven, the quintessential risk-off trade or the great inflation hedge. None of these descriptions, however, explain gold’s price movements long term. They certainly do not come close to explaining what happened from 2001 to 2011 when gold nearly octupled.
While the most sustained gold bull market in history was raging, the S&P 500 barely moved at all on net. That dispels the first two monikers, safe haven and risk-off. During the 2008 bear, gold fell hard as well. If gold is risk-off, that wouldn't have happened. As for the great inflation hedge, this label has slightly more credibility, particularly during the 1978 to 1980 gold bull market, when the annual inflation rate peaked at nearly 16% and set off a quintupling of the metal over a two-year period.
But while the term “inflation hedge” can characterize gold price movements over medium-term time periods like 1978 to 1980, it still doesn’t explain long-term gold price movements. The inflation rate has hovered around the 2% rate the Federal Reserve generally targets since 2000. It has, of course, gone above and below that rate at times, but inflation never really spiraled out of control during gold’s 11-year bull run.
The closest correlation to something resembling any of these descriptions in terms of a long-term chart is the dollar index.
While the correlation is not perfect (dollar index in blue), it’s much closer than any long-term correlation with the inflation rate or any inverse correlation with equities.
Admittedly, what exactly drives the long-term movement of gold prices eludes almost everybody. But perhaps we can try to triangulate using data we have from the 1978 to 1980 gold bull that correlated most closely with the inflation rate, and the 2001 to 2011 long-term gold bull that correlated most closely with the dollar index.
We know that a high inflation rate, say double digits, creates panic buying into gold. We’ve seen this before, not just in the U.S., but in every country where there is a general loss of faith in the national currency throughout the centuries of human financial history. We also know a sustained fall in a currency’s competitiveness against other currencies – which may or may not induce a high inflation rate – can sustain a long-term bull market for gold in that currency.
So what if we have both, namely high inflation and a sustained fall in the dollar index? This could theoretically create a bull market with elements of 1980 intensity combined with elements of a sustained long-term climb as well. In other words, a gold bull market with spurts of intensity that does not collapse back down after its peak or peaks. Yes, the 2001 to 2011 gold bull market has pulled back substantially, but it has not by any means collapsed down to pre-bull market levels as happened in 1980. Not even close.
Could this combination happen? I believe it can. And I believe it could be catalyzed by the next bear market in stocks. With annual sustained federal deficits of more than $1 trillion now and no way to contain inflation with substantially higher interest rates, a sustained bear market in stocks could spur the Federal Reserve to reverse its current tightening, aggravating inflation and dashing hopes that the Fed can ever tighten monetary policy in any sustained way. The U.S. dollar index would fall hard as well, possibly pushing it to new lows in the process.
Together, this could spur a new bull market in gold with much less downside after the inevitable top we saw in the aftermath of January 1980 or September 2011.
If the current correction in stocks then turns into a full-blown bear market in equities across the board, then this process could finally be sparked. That’s why gold may not fall with stocks this time, as it did in 2008.
Disclosure: Long GLD.Ă‚
