Gold’s Bubble Behaviour May Signal a Paradigm Shift

Bubble or Paradigm Shift?

Assets that rise rapidly above their long-term trend are usually set for a fall. That was the fate of gold after it peaked in late 1979, when the price of the yellow metal subsequently dropped by nearly two-thirds over the following five years.

This time, however, the picture looks different. Gold has risen by more than 60% this year in dollar terms, marking its best annual performance in 46 years. When adjusted for inflation, gold has never been more expensive. Investors are therefore confronted with a critical question:
Are we witnessing another speculative bubble, or does this rally signal a fundamental paradigm shift?

Gold as an Eternal Store of Value

Gold, often described as the eternal store of value, has preserved its purchasing power over millennia. Yet its market valuation has always reflected the prevailing monetary regime.

Historically:

• Gold was reset to higher levels following the credit collapse of the 1920s.
• It surged again in the second half of the 1970s as the “Great Inflation” took hold.
• Over the next two decades, gold languished as inflation subsided and real interest rates remained high.
• In the early 2000s, after Federal Reserve Chair Alan Greenspan slashed interest rates, gold entered a prolonged bull market.
• During the era of zero interest rates and quantitative easing from 2008 to 2022, gold remained volatile but continued its upward trajectory.

The Breakdown of a Long-Held Relationship

By the start of this decade, it had become accepted wisdom that gold prices move inversely to long-term real interest rates. This relationship appeared to hold in 2022, when gold prices fell sharply as central banks tightened monetary policy and bond yields climbed.

Then something unexpected happened. Despite falling inflation and rising inflation-adjusted bond yields, gold prices began to rise exponentially.

The Russian Reserves Shock and a Regime Change

According to Daniel Oliver of Myrmikan Capital, which invests in microcap gold miners, this regime shift can be traced back to the decision by then U.S. President Joe Biden to seize Russian foreign exchange reserves following Vladimir Putin’s invasion of Ukraine in February 2022.

That action shook the foundations of the international monetary system, in which the U.S. dollar had long served as the central anchor. Reserve managers at several central banks began searching for an asset that:

• Could not be seized, and
• Was not the liability of another sovereign state.

They turned back to the original reserve asset: gold.

Central Banks Lead the Buying

Over each of the past three years, central banks have purchased more than 1,000 tonnes of gold annually. Goldman Sachs expects these official-sector purchases to continue into next year.

Many emerging-market central banks still hold relatively small allocations to gold. For example, earlier this year China’s officially reported gold holdings amounted to only 6.5% of its total foreign exchange reserves, although some analysts believe Beijing’s true gold stockpile is far larger than officially disclosed.

Bubble Characteristics — Without the Mania

At first glance, gold’s price chart over the past three years resembles a classic investment bubble. However, one crucial ingredient is missing: irrational exuberance.

Speculators appear far more absorbed by cryptocurrencies and artificial intelligence than by what John Maynard Keynes once called the “barbarous relic.” Evidence of restrained enthusiasm includes:

• Gold-backed exchange-traded funds still holding more than 10% fewer ounces than at their October 2020 peak.
• The number of shares outstanding in the VanEck Gold Miners ETF has fallen by roughly one-third from its 2020 high.

Wall Street Remains Skeptical

Caesar Bryan, portfolio manager of the Gabelli Gold Fund, observes that Wall Street remains distinctly unenthusiastic about gold’s prospects. The consensus gold price forecast for 2028 among investment analysts sits nearly $1,000 below the current spot price.

The 1970s gold bull market was notoriously volatile and punctuated by severe drawdowns. Today’s investors have repeatedly braced for a correction, yet every modest setback has so far been swiftly reversed.

Having experienced numerous bull and bear markets over four decades in the gold business, Bryan remarks:

“It does feel different this time.”

Then Versus Now: A Stark Monetary Contrast

The monetary and fiscal backdrop of the 1979 gold bubble bears little resemblance to today’s environment.

In the late 1970s:

• The United States was a significant international creditor.
• Federal government debt stood at around 30% of GDP.
• The budget deficit was relatively modest.
• The federal funds rate had climbed to 14% and was still rising under Fed Chair Paul Volcker.

By contrast, today:

• The U.S. is the world’s largest debtor.
• Government debt is nearly four times higher as a share of GDP.
• Over the past three years, fiscal deficits have averaged around 6% of GDP, roughly four times the level seen in 1979.
• The policy interest rate is below 4% and falling.

President Donald Trump has made it clear that he does not want an inflation hawk like Volcker at the helm of the Federal Reserve. Moreover, the high leverage within the U.S. financial system and elevated asset valuations suggest that any attempt to recreate Volcker-style monetary tightening would likely end in disaster.

The Federal Reserve’s Balance Sheet Problem

Oliver also highlights the stark transformation of the Federal Reserve’s balance sheet. In 1979, the Fed’s assets consisted mainly of short-dated government securities, and the market value of its gold holdings exceeded its monetary liabilities.

Today, the Fed’s balance sheet is dominated by long-dated securities, including mortgage-backed bonds, many of which have generated substantial paper losses. While the market value of the Fed’s gold reserves has increased, they now cover only 16% of its liabilities, far below historical norms.

Gold as a Response to Systemic Uncertainty

Against this backdrop, it is reasonable to conclude that rising gold prices reflect deep fiscal, financial, and geopolitical uncertainty. However, for the bull market to persist, another shift may be required.

Central banks have already increased their gold holdings significantly. Most private investors, however, have not. According to Goldman Sachs, the optimal investment portfolio over the past decade would have allocated half of its assets to gold—a strategy few adopted.

Rethinking Safe Assets

Traditionally, asset allocators have relied on government bonds as a stabilizing force against volatile equities. In recent years, however, bonds have become positively correlated with stocks, meaning both tend to decline during periods of financial stress.

Gold, by contrast, has offered more effective protection. When U.S. equities sold off in the first quarter of this year, gold prices rose. Enthusiasts frequently point out that gold is the only truly risk-free asset.

Given that private investors currently maintain negligible exposure to the metal, even a modest dose of rational exuberance could propel gold prices significantly higher.

Source: Reuters Breakingviews – By Edward Chancellor