QUO VADIS: Playing with Monetary Fire_Gold and the Nuclear Option

Introduction

Gold has served as the ultimate refuge since time immemorial. Gold is a way to secure your money in times of financial crisis. Gold is also portable wealth for those who want to flee war. In light of Russia's invasion of Ukraine and the clash of arms in the Middle East, the boom in gold prices since 2022 does not seem all that surprising. But those who bother to take a closer look come to a quite different, and very worrying, explanation.

COVER MY GREENBACK

Gold has a formidable competitor as a safe haven: US government bonds. Gold is an interest-free asset. In the past, when real interest rates (i.e. adjusted for inflation) on US government bonds rose, gold prices invariably fell. 2022 brought a break with this past. That year, US real interest rates rose 3.6%, but the gold price remained surprisingly stable at $1,800, whereas previously an interest rate rise of that magnitude would have resulted in a gold price of $600. Just look at the long-term (cor)relationship between the gold price and real interest rates on 10-year US government bonds:

Figure 1: Gold price versus real 10-year US Treasury yield (in the last 20 years)

So, for 20 years, the gold price ran almost perfectly parallel to the inverse yield on US government bonds. Since 2022, however, we have seen a major divergence. More recently, this scenario repeated itself. In 2024, just as hopes of rapid interest rate declines evaporated, around the end of February, the gold price spiked and set a new record high.

GO WITH THE STOCK-TO-FLOW

International conflicts have tempered the downward pressure of higher real interest rates on gold prices but are in itself insufficient to explain the whole divergence. Most market observers seem to be at a loss. Some point to Chinese retail investors. Chinese citizens would not touch their own stock market with a ten-foot pole and have traditionally invested mainly in real estate. Now that the Chinese property market is collapsing, they are fleeing into gold. Unfortunately, contrary to what 99% of all articles and investors seem to believe, the gold price is not driven by trading in physical gold. There are two reasons for this. The first is that gold has an exceptionally high stock-to-flow ratio. Some 3,600 tonnes of new gold are mined every year (note: That sounds impressive, but 3,600 tonnes of gold fits into a cube only 5 metres high). However, there is a huge supply of gold in circulation. Gold is imperishable and carefully preserved. The total global gold supply - all the gold mined by humans over the past 6,000 years - stands at about 213,000 tonnes. Thus, annual mine production is only 1.7% of the existing gold supply. The annual demand for gold is slightly higher, almost 5,000 tonnes, but that too is only 2.3% of the gold supply. Fluctuations in (new) supply and demand therefore have little impact on the gold price. After all, on the (existing) supply side, there is 'always enough gold'. This is completely different as far as industrial metals or agricultural commodities are concerned. Indeed, their stock-to-flow ratio is much lower (see Figure 2). Copper prices, for example, have recently gone through the roof because of tensions in the physical market. Disruptions in some copper mines such as the Konkola mines in Zambia and in the Cobre Panama mine, lower output from Chinese copper smelters and strong demand exhausted available stocks in no time.

Figure 2: Stock-to-flow ratio gold versus commodities

The second reason why supply and demand in the physical gold market have little direct influence on the gold price is that in the gold market, the international gold price is determined by speculation in 'paper' gold on the LBMA (London Bullion Market Association, this is the 'Over-The-Counter market'), and on the Comex in New York (this is the futures market). Globally, an average daily equivalent value of $160 billion in gold is traded, largely virtually (without physical delivery):?

Figure 3: Average daily trading volume gold versus other assets (in dollar)

In terms of average traded value, (virtual) gold is more liquid than US Treasury bills (short-term US government securities), for example. The scale of speculation becomes really clear when you consider that the daily average of $160 billion is the equivalent of 2,500 tonnes of gold. That is two-thirds of all the gold mined globally in a single year. So, the value of physical gold trading is less than one hundredth of the equivalent value of total gold trading. In fact, the price of physical gold is based on the price of trading in virtual gold. In the gold market, the price of the underlying physical asset is derived from the derivatives market. In the gold market, the tail is wagging the dog.

The negligible direct impact of physical trading on the gold price can also be illustrated through gold ETFs. The sharp rise in the gold price since the fourth quarter of 2022 has not been accompanied by net inflows into gold ETFs, but by net outflows. Figure 4 shows the number of tonnes of physical gold held by the world's largest gold ETF, the SPDR Gold ETF.

SAFEKEEPING

Neither war nor the demand for physical gold provide a sufficient explanation for the gold price boom. To find the missing piece of the puzzle, we need to bring Euroclear, the discreet Belgian securities giant, into the picture. Euroclear processes a quadrillion euro - a number with 24 zeros - in transactions every year and it holds 38 trillion euros worth of securities in custody ('safekeeping'), including 200 billion euros from the Russian central bank.

Figure 4. Physical gold held by the SPDR Gold ETF versus the gold price

These assets, some two-thirds of Russia's total, have been frozen by the West to punish Russia for invading Ukraine. There are growing voices in Western political circles, with the European Commission, the US and the UK leading the way, in favour of using the Russian assets to help Ukraine. Today, the G-7 is weighing three options: skimming the proceeds of the assets, using them as collateral for loans to Ukraine or confiscating them. The third option has an extremely weak legal basis. One reason is that none of the G-7 countries is at war with Russia. A confiscation of Russian assets could therefore lead to a total breakdown of confidence in the European - and perhaps the global - financial system, a new Lehman moment. This scenario is a catastrophe for the European economy and for Belgium, with Euroclear in the role of bailiff rather than depositary, in particular. It deletes the 'safe' in 'safekeeping', turning the West into the lawless Wild West. Foreign powers inclined towards Russia could launch the mother of all bank runs on Western banks. Those countries are monitoring the situation with suspicion and blame the West for using double standards as it looked away when America invaded Iraq on the pretext of Iraq reaching for weapons of mass destruction. In a world where foreign state assets can be confiscated at will, international trade largely grinds to a halt.

MONETARY FIRE

The West is playing with monetary fire. China's central bank is feeling the heat and has been feverishly building up additional gold reserves for the past two years, coinciding with the freezing of Russian assets. With 225 tonnes, China's central bank accounted for a quarter of all central bank official gold purchases in 2023. China's unofficial purchases were 2 times higher still. Total purchases by the Chinese central bank represent about a quarter of all gold mined in a year, so that can count. Chinese purchases also continue unabated in 2024. Admittedly, they still have a long way to go if they want to convert their total foreign exchange reserves into gold. China's foreign exchange reserves are $3 trillion, the equivalent of 40,000 tonnes of gold.

The start of this year's new gold price boom coincides perfectly with the publication of the report to the European Parliament entitled 'Legal options for the confiscation of Russian state assets to support the reconstruction of Ukraine' and the speech on 28 February by the ever-zealous Ursula von der Leyen. She declared that "it is high time to deploy the profits of Russian assets ... there is no greater symbol that would make Europe a safer place." A safer place? It paves the way for the nuclear monetary option. And for an explosion of the gold price if the red button is pressed.

Jan Longeval, May 2024

Kounselor Consulting (www.kounselor.be)

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