The Golden Dilemma Redux: New Gold Rally May Set Stage for Future Price Plunge

A new research paper suggests the current surge in gold prices, fueled by gold ETF inflows and Chinese central bank purchases, may portend significantly lower real gold returns over the next decade.

A new research paper suggests the current surge in gold prices, fueled by gold ETF inflows and Chinese central bank purchases, may portend significantly lower real gold returns over the next decade.

The current surge in gold prices, fueled by inflows into gold exchange-traded funds (ETFs) and purchases by the Chinese central bank, may be setting the stage for significantly lower inflation-adjusted returns over the next decade, according to a new research paper by Claude B. Erb and Campbell R. Harvey.

The study, titled “Is There Still a Golden Dilemma?”, suggests that the real price of gold—the nominal price adjusted for inflation—is a key driver of future returns.

Historically, high real gold prices have been followed by low or negative real returns over the subsequent 10 years.

Gold ETF Inflows Linked to Doubling of Real Gold Prices

Erb and Harvey found that the launch of gold ETFs in 2005, particularly the SPDR Gold Shares (GLD) and iShares Gold Trust (IAU), coincided with a doubling of the real price of gold compared to pre-ETF levels.

The researchers observed a 0.74 correlation between the holdings of these two ETFs and the real gold price from 2010 to 2023, suggesting that ETF inflows have been a significant driver of the recent rally.

The authors used data from Bloomberg on gold futures prices and inflation indices dating back to January 1975, as well as estimates from the World Gold Council on the above-ground gold stock held by various market segments.

By decomposing the nominal price of gold into an inflation component and a real price component, they found that fluctuations in the real price of gold empirically drove nominal gold price movements, with essentially zero correlation between nominal gold returns and inflation.

This finding challenges the conventional wisdom that gold serves as an effective hedge against inflation.

Instead, the researchers argue that the real price of gold is the primary determinant of future returns, with high real prices portending low or negative inflation-adjusted returns over the next decade.

China’s Push for “De-Dollarization” May Further Inflate Gold Bubble

Another potential factor inflating the gold bubble is China’s recent push to diversify its reserves and promote “de-dollarization”—a move away from the U.S. dollar as the dominant global currency.

The authors suggest that if China were to triple its gold reserves per capita to match U.S. levels, it could significantly boost real gold prices in the near term.

However, this would likely exacerbate the overvaluation and set the stage for even lower real returns in the future.

China’s gold purchases, which have been officially reported for 17 consecutive months, are part of a broader trend among central banks in the “Global South” to shift away from U.S. Treasuries and European bonds.

While the exact magnitude of China’s gold holdings is shrouded in mystery, due to the country’s history of opaque reporting, the researchers argue that even a moderate increase in reserves could have an outsized impact on real gold prices.

Researchers Warn High Real Gold Prices Historically Lead to Low Future Returns

The study’s findings underscore the historical pattern of high real gold prices preceding weak long-term performance.

As Erb and Harvey note in their paper, “High real gold prices presage future unattractive real gold returns.

Gold purchases and sales by market participants, such as gold owning ETFs and ‘de-dollarizing’ central banks and others, can affect the real price of gold and prospective real gold returns.”

“Today’s golden dilemma is yesterday’s golden dilemma,” the researchers write. “Has an influx of gold buying ushered in a new age of permanently and perpetually rising real gold prices or has it simply set-up real gold prices for a significant fall?”

While the prospect of a new gold standard driven by China’s de-dollarization efforts may seem alluring to some investors, Erb and Harvey caution against extrapolating the current rally into the future.

As the saying goes, all that glitters is not gold — and in this case, it may be a warning sign of a market overheating.

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