Gold rise inexplicable? Morgan Stanley's new pricing model has a fit of 0.94, aiming for $3,100 early next year

Recently, the price of gold has risen "unreasonably", not only hitting new highs repeatedly, but also deviating from the trends of the US dollar and oil prices. According to Deutsche Bank's exclamation, gold has shown exceptionally strong performance, far exceeding the valuation of traditional models, reaching the highest level of deviation since 1998.

In response to this, Morgan Stanley has developed a new regression model to measure changes in the price of gold. In a report on October 23, Morgan Stanley pointed out that the old relationship has broken down and a new price model has been generated:

Due to the long-term inverse relationship between gold and US real yields breaking down at the beginning of 2022, the research team developed a new regression model, incorporating factors such as ETF flows, central bank reserves, Consumer Price Index (CPI), US Dollar Index (DXY), global risk index, and net futures positions. This significantly improved the model fit, increasing from 0.31 when using the 10-year TIPS yield to 0.94 for 2003-24.

Regarding the factors influencing the price of gold, Morgan Stanley stated:

Over the past five years, the influence of ETF holdings, central bank purchases, and investors' positions in the futures market on gold has increased. Other factors that high-frequency data cannot capture, such as demand for gold bars and coins, over-the-counter trading, mining supply, and recycling, also affect the price of gold.

Despite rising interest rates recently, the price of gold has continued to rise, driven by increased central bank purchases and strong demand for gold bars and coins, while rising mining costs have also provided support for prices.

According to the model calculations, Morgan Stanley pointed out that the price of gold may continue to rise, with a possible upward trend to $3100 per ounce in the first quarter of next year:

The price of gold has exceeded the forecast of $2700 per ounce for the first quarter of 2025, and there is a possibility of further price increases in the near future, especially in the case of interest rate cuts.

The possible range for the price of gold in the first quarter of 2025 is $2500 to $3100 per ounce, depending on factors such as interest rates, ETF flows, and central bank gold purchases.

Taking into account factors such as marginal costs, project incentive pricing, and regression analysis, the long-term forecast for the price of gold remains at $1900 per ounce.

Breakdown of the Old Relationship, Generation of a New Model

Firstly, the divergence of gold prices from the trends of the US dollar and oil prices is attributed to the breakdown of the old relationships, as pointed out by Morgan Stanley:

Since the beginning of 2022, the long-term inverse relationship between the price of gold and US real yields (10-year TIPS) has broken down. Previously, in a rising interest rate environment until the end of 2023, gold prices would typically fall.

The chart below shows a clear turning point, but this does not mean that the two are unrelated. In fact, a negative slope has solidly recovered since mid-June. However, looking at a time frame of 6-12 months, it is evident that there are more factors influencing the price dynamics of gold.

Therefore, Morgan Stanley has introduced additional high-frequency factors in the new regression model to improve the fit and conduct sensitivity analysis.

1. U.S. Real Bond Yield: The U.S. 10-year Treasury Inflation-Protected Securities (TIPS) yield is a typical indicator of real yield. It is expected that by the end of 2024, the 10-year real yield will decrease to 1.65%, drop to 1.30% by mid-2025, currently around 1.76%. The cost of holding gold decreases as the real yield declines, usually boosting demand for gold.
2. ETF Holdings: Over the past 5 months, there has been a net inflow into global gold ETFs. This trend is expected to continue with further interest rate cuts. Inflows in North America are the main driver of global flows, while Asia has seen inflows for 19 consecutive months. Currently, global ETF holdings are around 103 million ounces, 18% lower than the peak of 125 million ounces at the end of 2020.
3. Central Bank Reserves: Since 2022, central bank purchases have increased, with annual net purchases exceeding 1000 tons globally in 2022 and 2023, more than twice the average speed since 2011. The growth rate remains the same in the first half of 2024 compared to the previous year.
4. U.S. CPI Index: The U.S. CPI index sharply rose in 2021-22 due to supply chain disruptions caused by the pandemic and the Russia-Ukraine conflict. However, inflation has slowed down as energy prices and supply chains normalize.
5. Global Risk Index: Perception of geopolitical and macroeconomic risks has increased, potentially attracting investors to use gold as a safe haven asset. Matteo Iacoviello's geopolitical risk index had a 7-day rolling average of around 145 in October, significantly higher than the median value. However, it spiked to 438 after the start of the Russia-Ukraine conflict in 2022 and exceeded 800 after the 9/11 attacks in 2001.
6. U.S. Dollar Index: The value of the U.S. dollar against other currencies fluctuates due to U.S. interest rates and its economic health, thus showing some covariance with the 10-year TIPS yield.
7. Futures Positions: Non-commercial positions in the U.S. futures market show a significant increase in investors' long positions this year, with net long positions peaking at 315,400 contracts by the end of September, more than double the level in February, before slightly retreating in October.

It is worth mentioning that the relationship between factors affecting the gold price and gold itself is also undergoing dynamic changes, as stated by Morgan Stanley:

Over the past 5 years, the weights of ETF holdings, central bank reserves, and futures positions have increased in the regression analysis. Similarly, the global risk index has shifted from a positive correlation with prices to a negative correlation over the past 5 years, with the lowest statistical significance among all driving factors.

Gold Price to Explore $3100 in the First Quarter of Next Year?

Regarding the recent rise in gold prices, Morgan Stanley analysis points out that ETFs have shifted from outflows to inflows of gold bars, central banks continue to make purchases, and gold bars and coins are attracting new investors:

ETF net inflows have turned positive in the past 5 months, with global holdings having room to rise, currently 18% lower than at the end of 2020. Central bank gold purchases are a long-term trend. Demand for gold bars and coins is better than jewelry in a high-price environment, with strong growth in Asian markets, led by China and India; additionally, jewelry demand is expected to decline by 19% in the second quarter of 2024, with prices at new highs, and short-term jewelry demand fluctuations still dependent on prices.

Overall, through regression analysis, Morgan Stanley concludes that compared to the recent gold price of around $2700 per ounce, the "low," "medium," and "high" price sensitivities are $2500 per ounce, $2800 per ounce, and $3100 per ounce, respectively.

With declining interest rates and real yields, elastic investment demand, including from central banks, gold bars and coins, and over-the-counter trading, aligns with the gold price facing positive returns in the first quarter of 2025, already surpassing our base case of $2700 per ounce.

Our regression model indicates that under baseline conditions, with the U.S. 10-year TIPS yield (1.30), DXY (102), and CPI index (319), along with the continued pace of ETF flows and central bank purchases, the gold price in the first quarter of this year is around $2800 per ounce, while under aggressive forecasts, the price could reach $3100 per ounce.

Furthermore, supply growth driven by high prices and jewelry demand weakness should help alleviate market tightness and prices starting from the mid-2025. Maintaining the long-term price based on marginal costs, project incentive pricing, and regression analysis at $1900 per ounce