During the period of aggressive interest rate hikes by the Federal Reserve, gold has exhibited intriguing resilience. Despite the continuous rise in interest rates, gold prices have not fallen, but rather increased. This contravenes its traditional valuation model of an inverse relationship with the 10-year U.S. real interest rate and the dollar.
This unexpected trend can be traced back to an unusual force - central banks. Amid relatively stable investment and jewelry demand, purchases by central banks have reached unprecedented levels.
However, with high real interest rates persisting and the risk-averse impulse sparked by the banking crisis in March exhausted, it is crucial to determine whether the gold rush of central banks can continue to support gold prices in the future.
Last week, a research report released by a team led by UBS analyst Elena Amoruso examined the appropriate weight of gold in central banks' reserve investment portfolios. The report found that the optimal allocation of gold ranged between 0.5% and 11.5%. The increment of gold holdings was only deemed reasonable when the target investment portfolio's term exceeded six years.
Moreover, UBS suggests that despite the current trend of deglobalization, central banks might not significantly increase their gold purchases, potentially limiting gold's future trajectory. However, traditional supports might return with the potential end to the Fed's rate hike cycle, and the softening of the dollar and declining U.S. real interest rates may alleviate gold's predicament.
Gold's Optimal Allocation: Balancing Risk and Return
UBS utilized a risk-return tradeoff to consider the proportion central banks can assign to gold in their portfolio construction, providing predictions for official gold demand.
UBS studied typical central bank portfolios' responses to precious metals, focusing on four different term government bond investment portfolios (6 months - 6 years and beyond) and a conservative multi-asset investment portfolio composed of 80% government bonds and 20% developed market stocks.
For the multi-asset investment portfolio, UBS selected the SCI World Index, which designates approximately 60% to U.S. stocks, with the rest invested in other developed market stocks.
These portfolios mimic the composition of existing central bank reserve investment portfolios with varying durations and levels of equity risk exposure.
UBS evaluated the impact of increased gold allocation on its five model investment portfolios, finding that the higher the risk of the portfolio, the greater the returns from diversifying into gold.
Specifically, cash equivalents and short-term fixed-income portfolios (6 months and 1.5 years) hardly benefit from increased gold allocation, with the risk-adjusted return rate plunging to 0.5%.
However, for longer-term portfolios, gold played a significant role in hedging against changes in returns.
At the peak risk-adjusted return rate, the weight of gold in the 3-year term portfolio was 3.5%. When the portfolio term exceeded 6 years or included stocks, the optimal gold allocation was around 10%, with the highest risk-adjusted return rates at gold weights of 11.5% and 8.5%, respectively.
UBS pointed out that even a minimal increase in gold allocation in a portfolio causes a rapid rise in return volatility. There is an almost linear relationship between incremental gold allocation and volatility.
Technically, all portfolios can achieve the lowest return volatility with a gold allocation of 0%. However, a small gold allocation (up to 5% for most portfolios and up to 10% for the longest term fixed income and multi-asset portfolios) does not seem to pose a significant threat.
Moreover, beyond these thresholds, the return curve only steepens dramatically, suggesting that a certain amount of gold allocation can achieve optimal risk-adjusted returns without excessively disrupting portfolio volatility.
However, the risk profile of the longest-term and multi-asset portfolios doesn't decrease significantly until gold allocation surpasses 10-15%.
Overall, UBS's analysis indicates that the optimal gold allocation for a standard central bank reserve investment portfolio typically falls between 0.5% and 11.5%, depending on the portfolio's duration and risk exposure.
Central Banks' Gold Rush Unlikely to Continue, Traditional Factors to Resurface
According to UBS, developed economies appear to be over-allocated in gold. Despite this, it is challenging to reverse central banks' enthusiasm for gold after the global financial crisis. UBS noted in its report:
For many of these countries, gold reserves are a historical legacy. Selling gold could conflict with public sentiment and national pride. It seems that portfolio diversification and returns are not their primary concerns.
This is evident from the trend of European central banks selling gold recently. Emerging market central banks face more nuanced decisions. Deglobalization pressures might push them to increase gold allocation, but balancing risk/return and liquidity needs might prevent such defensive moves.
UBS stated that duration is vital in deciding gold allocation. It's only reasonable to hold more than 3.5% gold when the investment portfolio duration exceeds three years. Given the shortening reserve investment portfolio duration post-Covid (currently the median is just 20 months), raising gold allocation to 7.8% from a pure risk-return perspective does not seem justified.
However, in a geopolitical environment encouraging diversification away from dollar/euro-denominated assets, gold, particularly domestically stored gold, offers unparalleled security.
UBS noted that this could still conflict with their need to maintain dollar/euro liquidity to intervene in balance of payments imbalances and their currencies. In this case, their gold would be best stored in foreign institutions, where it can serve as collateral for foreign exchange loans.
Predicting the future course becomes more challenging when economic and geopolitical factors intertwine.
UBS anticipates that central banks' gold purchases in 2023 are unlikely to reach the levels seen in 2022. But if the Fed ends its rate-hike cycle, the dollar weakens, and U.S. treasuries strengthen, traditional macroeconomic factors supporting gold might resurface.
