The bull market for gold has not ended

Since our report "Optimistic about Gold Prices Reaching New Highs This Year" on February 29, gold has entered a new bull market, with the year-on-year increase in gold prices reaching as high as 45%. The last time such a significant increase occurred was during the quantitative easing period in 2011.

After the dust settled from the U.S. elections in November, gold prices fell by 5.3% within seven trading days, marking the largest decline since March 2022 (seven consecutive trading days). The market began to worry whether the gold bull market had already ended.

To answer this question, we must first grasp the main driving force behind the rise in gold prices over the past two years—central bank reserves.

"In our report 'How is Gold Priced?' (January 21, 2023), we mentioned that the two-factor model of real interest rates and VIX historically has a strong explanatory power for gold prices, but it failed in 2022 because central bank gold reserves reached new highs supporting the gold price trend.

The two-factor model composed of VIX and real interest rates reflects that gold is a risk-averse asset in the short term and a shadow of currency in commodities in the medium term. The model overlooks the long-term pricing scale of gold prices, which represents deep concerns about the global credit currency system.

We used the annual increment of central bank gold reserves to proxy this long-term concern and reconstructed a two-factor gold price fitting model with real interest rates and central bank gold reserves on an annual frequency (since it is annual data, VIX was not considered as a short-term pricing scale). The results showed that the new two-factor model can also explain over 80% of the fluctuations in gold prices, and both explanatory variables are very significant (P-value is 0).

In the historical context from the subprime mortgage crisis to 2021, the general direction of real interest rates was downward, while central bank gold reserves were increasing, with both driving gold prices positively. It was not until 2022 that the driving force of real interest rates diverged from reality, and the market realized that changes in central bank gold reserves might also be an important pricing factor for gold prices, suggesting that the explanatory power of real interest rates for gold prices might have been overestimated."

—— "The Super Long Cycle of Gold—Gold Pricing Series Report II" (March 22, 2023)

This year, the World Gold Council announced that quarterly data on gold reserves has declined compared to the same period last year, with the cumulative year-on-year increase in central bank reserves in the first three quarters down by 17%, a decrease of 140 tons. Meanwhile, the People's Bank of China, as the country with the largest increase in gold reserves in 2023, suspended its purchases from May this year and only resumed buying in November. At the same time, the real interest rate on U.S. Treasury bonds has also fluctuated upward from the beginning of the year, rising from 1.72% at the end of last year to the current 2.07% (as of November 22).

The two most important pricing factors for gold seem to be bearish, yet gold prices have risen from $2,063 at the end of last year to the current $2,632.66. Does this mean that there are driving factors that the model has not captured? **

The rise in real interest rates has suppressed the financial attributes of gold, affecting institutional investment behavior. This year, the scale of gold ETF products continued the decline seen last year, indicating that institutional investment demand is still weakening. However, compared to last year, the pace of ETF scale reduction has slowed, with a decrease of 163 tons. This is because, in addition to financial attributes, election and geopolitical factors contributing to risk aversion are also reasons for institutions to hold gold.

It is difficult to judge central bank purchases solely by observing the central bank's balance sheet, as changes in gold holdings on the balance sheet are only part of the reserves. For example, according to data from the World Gold Council, the comprehensive increase in gold reserves of central banks in 162 countries and regions published monthly in 2023 was only 361.4 tons, while the total increase in global national reserves for the year was 1049.1 tons. The difference of 688 tons represents reserve changes not reflected in the monthly published central bank balance sheets.

In the first three quarters of this year, the item with the largest increase in demand in the World Gold Council's quarterly balance sheet was over-the-counter and other demand (OTC and Other), which was 190 tons more than in the first three quarters of last year. According to the World Gold Council's definition, this figure is used to balance the supply-demand balance sheet and can be understood as the "residual item" after subtracting explicit demand (residential demand + central bank purchases) from gold supply. Although central bank purchases in the first three quarters of this year were 140 tons less than last year, the total demand unrelated to residents (investment + consumption + industrial use) was 50 tons more than last year.

The gold demand data provided by the China Gold Association shows a similar situation. In the first three quarters of this year, domestic raw gold production was 379.3 tons. According to customs data, the import value of gold (unrefined gold and semi-finished gold products, HS7108) in China for the first three quarters was USD 67.29 billion. Based on the average annual price of gold in London at USD 2634 per troy ounce, the import volume of gold in China for the first three quarters was approximately 794.65 tons. Adding the import volume to domestic production, the total supply was 1173.95 tons.

According to data from the China Gold Association, the total consumption of gold in China in the first three quarters of this year was 741.7 tons (including 400 tons of gold jewelry, 282.7 tons of gold bars and coins, and less than 60 tons for industrial and other uses), which also implies that the unobserved demand or implied inventory in the first three quarters of this year was approximately 432 tons (including central bank reserves), far exceeding the 29 tons increase shown on the central bank's balance sheet. According to the same algorithm, the net imports in 2023 are approximately 1,327.39 tons, with production at 519.29 tons and consumption at 1,089.69 tons (gold jewelry 706.48 tons, gold bars and coins 299.60 tons, industrial and other gold 83.61 tons). The increase in central bank reserves is 224.88 tons, and the unobserved demand or implied inventory (including central bank reserves) is 756.99 tons.

The so-called "unobserved demand or implied inventory" refers to unconventional demand, such as jewelry consumption, industrial gold, investment, and direct purchases by central banks, which have already been reflected in the table. The remaining amount is likely another form of reserves. If we aggregate the "residual item" and changes in central bank reserves, the annualized demand increase for the first three quarters of this year (1,595 tons) is higher than last year (1,509 tons), indicating that reserve demand has not weakened and may even be increasing.

These changes in data also align with the global central banks' attitudes towards gold reserves in recent years. The 2024 Central Bank Gold Reserve Survey (CBGR) shows that 29% of central banks plan to increase their gold reserves in the next 12 months (up from 24% in 2023), and 69% of central banks believe that the proportion of gold in global reserves will rise over the next five years (up from 62% in 2023).

It is important to note that this year, investment demand for gold has also seen a significant rebound, increasing by 148 tons in the first three quarters compared to the same period last year (with ETFs increasing by 163 tons), ranking second among all demand categories only after the "residual item." Institutional investors are increasing their gold holdings against the backdrop of rising real interest rates, possibly based on risk aversion or momentum effects in a bull market. Considering that the total holdings of global gold ETFs are still at low levels compared to the past few years, there is still objective room for an increase in allocation demand in the future, which is a strong support for the upward space of gold prices.

The geopolitical and financial environment is becoming increasingly complex, making gold reserve management more relevant than ever. Trump's return does not seem like an epilogue, but rather a prelude. As tariffs transition from "campaign promises" to reality, the intensity of de-dollarization will continue to rise, further reinforcing the global central banks' attitude towards increasing gold reserves. As the most important driving force of the current gold bull market, there are currently no signs of reversal or even weakening, and gold should continue to maintain a bullish outlook.

Author: Song Xuetao (S1110517090003), Lin Yan, Source: Xuetao Macro Notes, Original Title: "The Bull Market for Gold Has Not Ended"

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