• 2024-08-14
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Gold Soars: Dollar Crash Drives Pricing

Why does the price of gold keep hitting new highs? What does the skyrocketing price of gold mean?

In just the past year alone, the price of gold has risen by 50%, and several economists have predicted that the price of gold will rise above $3,000 per ounce.

Why has the price of gold risen so dramatically?

Gold is an extremely unique investment, possessing the triple attributes of currency, finance, and commodity.

The monetary attribute of gold is to understand gold as a form of currency, where the price of gold is the exchange rate of gold against the US dollar, similar to the exchange rate of the Japanese yen against the US dollar. If the production of gold increases, it will depreciate against the US dollar, and if the US prints more dollars, it will depreciate against gold.

Next is the financial attribute. The financial attribute of gold is to understand gold as a financial investment product.

As the saying goes, "antiques in prosperous times, gold in troubled times." Gold is one of the most important types of risk-averse assets.

When global geopolitical conflicts intensify or major risk events occur, funds will flow massively into gold to seek shelter, which is the core investment value of gold.

However, gold itself does not generate interest and is a non-interest-bearing asset. Therefore, holding gold means giving up interest, which is also giving up the interest income from US Treasury bonds, which are also risk-free assets.

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Thus, if the real interest rate of US Treasury bonds rises, the cost of holding gold increases, the attractiveness of gold decreases, and the price of gold falls.Finally, there are the commodity attributes of gold. Understanding gold as a commodity, such as using it for jewelry or electronic components, is the essence of its commodity attribute.

From the perspective of commodity attributes, if the consumption of gold increases rapidly, then the price of gold will rise. The price of gold is determined by these three attributes.

At present, the factors frequently mentioned and driving the rise in gold prices are mainly due to the financial attributes of gold, which are:

Global instability;

High inflation in Western countries;

A wave of interest rate cuts by global central banks;

A decline in the real interest rates of U.S. Treasury bonds.

Therefore, the investment value of gold is highlighted, and the price of gold rises.

However, in fact, these factors are not the core reasons for the current rise in gold prices.Historically, these four factors have either always been present or have appeared periodically, and these reasons do not explain why gold prices continue to hit historical highs.

Gold Exchange Rate Against the US Dollar

In fact, the most core factor determining gold prices has always been its monetary attribute, that is, viewing gold prices as the exchange rate of gold against the US dollar.

Gold was once the global reserve currency, but later, with the collapse of the Bretton Woods system, its position was replaced by the US dollar. It can be said that from the beginning, gold has been the opposite of the US dollar, and the core logic of gold pricing is its exchange rate with the US dollar.

Because the reserves of gold are limited and the production is very low, the total amount of gold is fixed, while the US dollar is exactly the opposite. In recent years, due to the Federal Reserve's repeated quantitative easing, the scale of the US dollar's stock has grown larger and larger.

The fixed quantity of gold and the sharp increase in the quantity of the US dollar mean that, from the perspective of exchange rates, gold will appreciate against the US dollar.

This is a chart showing the trend of gold prices and the balance sheet size of the Federal Reserve. Since the US dollar is a liability of the Federal Reserve, the balance sheet size of the Federal Reserve is equivalent to the stock size of the US dollar.

It can be seen that the rise in gold prices is almost synchronized with the increase in the scale of the US dollar.

The first round of gold price surge began in 2007-2008, which is the time when the Federal Reserve first introduced quantitative easing after the subprime mortgage crisis.

From 2008 to 2012, gold prices continued to rise along with the balance sheet size of the Federal Reserve.By the end of the third round of QE by the Federal Reserve in 2014, the gold price and the Fed's balance sheet size stabilized in tandem, after which they fluctuated back and forth for six years.

The second major surge in gold prices occurred in 2020, following four circuit breakers in the U.S. stock market and the Fed's initiation of unlimited quantitative easing, the gold price soared along with the Fed's balance sheet.

It can be observed that from 2007 to 2020, the major trends in gold were accompanied by significant monetary easing by the Federal Reserve.

During this period, the logic behind the rise in gold prices was straightforward: the more dollars were printed, the more the dollar depreciated relative to gold, and the more dollars were printed, the higher the gold price rose.

In theory, the monetary attribute of gold determines the overall trend of gold prices, while the other two attributes: financial and commodity attributes, drive gold prices to fluctuate around the exchange rate of gold to the U.S. dollar.

However, as time entered 2022, this core pricing logic for gold, which had been repeatedly verified, failed.

Uncontrolled Gold Prices

In June 2022, the Federal Reserve initiated quantitative tightening, also known as QT balance sheet reduction. Over the following two years, up to the third quarter of 2024, the Fed's balance sheet shrank by nearly two trillion U.S. dollars.

In theory, when the Fed eases monetary policy, gold prices rise, and when the Fed tightens monetary policy, gold prices fall.

However, over the past two years, despite the Fed tightening and raising interest rates, causing the dollar to continuously appreciate relative to other global currencies, gold prices have acted contrary to expectations. Instead of falling against the dollar, they have accelerated their upward momentum, rising directly from $1,750 per ounce to $2,750 per ounce.The price of gold is the exchange rate of gold against the US dollar. Why, when the Federal Reserve raises interest rates and shrinks its balance sheet, causing the US dollar exchange rate to soar, does gold break free from the control of the US dollar and rise against the market for two years?

We have mentioned before that the US dollar, by replacing gold, has become the global reserve currency. The core value of the US dollar is its status as a reserve currency.

If the US dollar's reserve currency status is solid and the US dollar hegemony does not decline, then the price of gold is determined by the speed at which the Federal Reserve prints money, which is the quantity ratio of gold to the US dollar.

However, if the US dollar hegemony declines and the credit of the US dollar collapses, then the global monetary system will be reconstructed, and the pricing logic of gold will undergo a fundamental change.

To put it bluntly, if the US dollar system collapses, it will not only cause chaos for the US dollar but also for the global financial market. At that time, in order to compete for the status of reserve currency, global geopolitical conflicts will inevitably intensify, and the status of gold will inevitably rise.

There is even a possibility that gold will once again become the most important reserve currency in the world.

Central Bank Gold Purchases

Let's look at a set of data:

In 2022, the same year when the Federal Reserve raised interest rates and shrank its balance sheet, global central banks' gold purchases reached 1,136 tons, which is the highest annual gold purchase by global central banks since records began in 1950, reflecting the strong demand of global central banks for gold as a reserve asset.

In 2023, global central banks continued to increase their holdings of gold, with a cumulative net gold purchase of 1,037.38 tons for the year, maintaining a high level.In the first half of 2024, despite a significant increase in gold prices, the enthusiasm of central banks worldwide for purchasing gold remained undiminished, continuing to net purchase 483.33 tons of gold.

On October 15, 2024, central bank officials from Mexico, Mongolia, the Czech Republic, and several other countries publicly expressed their support for continuing to increase gold purchases at the London Bullion Market Association's annual conference held in Miami.

We all know that in the foreign exchange reserves of central banks worldwide, the US dollar once dominated alone.

However, since 2008, when the Federal Reserve started its nuclear-powered money printing press, the proportion of the US dollar in global foreign exchange reserves has been continuously declining.

In 2000, the proportion of the US dollar in global foreign exchange reserves was 71.2%;

In 2015, the proportion decreased to 65.74%;

In 2020, the proportion decreased to 61.27%;

In 2023, it further decreased to 58.36%.

Central banks worldwide are continuously selling US dollars and buying gold.

Even with skyrocketing gold prices, the Federal Reserve's interest rate hikes and balance sheet reduction, and the US dollar's continuous appreciation relative to G7 currencies, everyone still does not want to hold US dollars.Before 2020, although the Federal Reserve had also printed a large amount of money, there were still a minority of people who worried about the decline of the dollar's hegemony and believed that the dollar would lose its status as the global reserve currency. However, after 2020, especially after the two administrations of Trump and Biden recklessly incurred debt and massively increased fiscal deficits, more and more people began to believe that the dollar's hegemony would decline and that the dollar would collapse.

At present, the core issue determining the price of gold has become: Will the dollar collapse? When will the dollar collapse?

Will the dollar collapse?

The issuance pattern of the dollar is very simple, that is, the Federal Reserve prints money to buy Treasury bonds and then issues dollars.

U.S. Treasury bonds are the credit collateral for the dollar. After all, the credit of the dollar is the credit of U.S. Treasury bonds, and the credit of U.S. Treasury bonds is equal to the credit of the U.S. government.

To understand whether the dollar will collapse, it is essentially answering another question:

Will the U.S. fiscal finances go bankrupt?

The financial situation of a country is similar to the financial situation of a family. If a family has fewer and fewer ways to make money, and more and more places to spend money, relying on borrowing to get by year after year, then this family will go bankrupt sooner or later.

In fact, the degree of fiscal deficit in the United States is far beyond our imagination. It is not an exaggeration to say that the bankruptcy of U.S. fiscal finances is only a matter of time.First, let's look at the revenue side on the left. The revenue side of the U.S. fiscal situation is straightforward and mainly consists of taxes, among which, personal income tax and social insurance tax account for more than 85% of fiscal revenue.

In the last century, corporate income tax in the United States was an important source of fiscal revenue, with a share exceeding 20%. However, due to the continuous relocation of business and profits by American multinational corporations, leading to the hollowing out of the U.S. industry, coupled with the 14% reduction in corporate income tax implemented by Trump in 2017, this type of tax has been effectively abolished since then.

With insufficient tax revenue, the U.S. has to rely on deficit financing. It can be observed that in the fiscal expenditure of the first seven months, more than a quarter, or $1.5 trillion, is in deficit. In other words, for every $4 spent by the U.S. government, $1 is borrowed.

Now, looking at the expenditure side on the right, the expenditure side is actually the most despairing.

U.S. fiscal expenditure is divided into three parts: "mandatory spending," "discretionary spending," and "interest spending."

"Mandatory spending" refers to expenditures that must be made according to legal provisions, including social security, healthcare, pensions, etc.

"Mandatory spending" is usually not included in the federal budget and will automatically be renewed according to the law. In other words, it is difficult to reduce this part of the expenditure.

Over the years, to attract voters, both parties in the United States have competed to promise tax cuts and increased benefits during elections, so this part of the expenditure has been increasing.

In 2023, "mandatory spending" accounted for 65% of U.S. fiscal expenditure, which is the heaviest burden on U.S. finances.

Then there is "discretionary spending." "Discretionary spending" is the expenditure that the President of the United States can control through the budget process, which is further divided into defense spending and non-defense spending.In 1963, "mandatory spending" accounted for only 25% of the budget, but by 2023, this proportion had risen to 65%. Conversely, "discretionary spending" represented as much as 67.6% in 1963, but has now dropped to 21.6%. From 1963 to 2023, U.S. fiscal revenue increased by 42 times, and fiscal expenditure increased by 55 times, but "mandatory spending" increased directly by 133 times. In other words, the fixed expenditures that the U.S. fiscal budget cannot suppress are getting higher and higher. In comparison, the meager defense spending during this period only increased by 15 times. Everyone talks about the military-industrial complex squandering resources and being insatiable, but in reality, the current U.S. defense spending is not even higher than the interest expenditure, accounting for only 12.8% of the total expenditure.

Lastly, "interest expenditure" refers to the interest paid by the U.S. government on its national debt. As mentioned earlier, the scale of U.S. debt has increased sixfold in 20 years, with more and more debt being borrowed, and naturally, the interest follows suit. From 2013 to 2023, U.S. "interest expenditure" rose from $220 billion to $659.3 billion, tripling in ten years. Currently, interest expenditure accounts for 13.6% of U.S. fiscal expenditure, making it the second-largest financial burden shouldered by the U.S. government.

Fiscal Cliff of the Empire

In summary, although the scale of U.S. fiscal expenditure is vast, about 80% of it, namely "mandatory spending" and "interest expenditure," is fixed and can hardly be reduced. Even with a change in the presidency, efforts to cut expenditures can only be made in discretionary spending, which includes both defense and non-defense spending.Let's make a bold assumption: if the U.S. government were to eliminate all defense and non-defense spending, and the U.S. military were to put away their weapons and horses, this would save approximately 21% of fiscal expenditures.

However, in the last four years, the U.S. fiscal deficit has accounted for about 34% of fiscal spending, which means that even if all "discretionary spending" were cut, it would still not be enough to fill the massive fiscal deficit.

The empire's fiscal expenditure gap can only increase and not decrease, therefore, there is no upper limit to the scale of U.S. debt.

This is a chart showing the trend of the U.S. federal government's fiscal deficit over the past 60 years.

It can be seen that, except for a brief period of fiscal surplus during Clinton's second term, at other times, the fiscal deficit has grown larger and larger, especially since 2020, when the deficit has swelled to an astonishing level.

In 2000, the scale of U.S. national debt was still around 5 trillion U.S. dollars, and now it has risen to more than 35 trillion U.S. dollars.

In 2000, the proportion of U.S. national debt to GDP was 55%, and by 2023, this indicator has risen to 121%, more than double.

Debt Monetization

A government of a country has only four ways to solve debt problems:

First, debt restructuring, in simple terms, is to reduce the debt burden through debt default or debt write-off, which is equivalent to not paying back the debt;Second, there is the compression of expenditures, which means the government tightens its belt and pays off the debt bit by bit; third, there is the redistribution of wealth, which, in simple terms, means using residents' and businesses' wealth to repay debts through taxation; fourth, there is the monetization of debt, which is essentially printing a large amount of money and diluting debt by increasing the inflation rate.

As mentioned earlier, in order to please voters, the U.S. government is unable to raise tax rates or compress expenditures. Therefore, to repay the huge U.S. debt, there are only two options left:

First, debt restructuring, which is equivalent to a U.S. debt default, and the U.S. dollar's credit would immediately go bankrupt;

Second, debt monetization, which means continuing to print money, boiling the frog in lukewarm water.

Weighing the lesser of two evils, since no U.S. administration wants the U.S. debt to explode during their term, and they cannot afford the consequences of the U.S. dollar collapsing, the U.S. government can only choose the last path - debt monetization.

The U.S. government knows it is debasing its currency to pay off debt, and global central banks also know that the U.S. government will inevitably debase its currency to pay off debt. Since the dollar's debasement is already an open secret, everyone will inevitably accelerate their embrace of gold, which is the biggest logic behind this year's soaring gold prices.

Finally, let me share my view on gold: neither bullish nor bearish.

I am not bullish because the current gold price is not low, and the logic supporting the rise in gold prices is mostly so-called grand narratives. Grand narratives are slow variables, and it is difficult to grasp the timing of their impact. Even if the U.S. dollar system will collapse sooner or later, this is not something we can see in a day, so it is hard to say how high the gold price can surge in the short term.Then there is the perspective of not being bearish; the rationale supporting the rise in gold prices is very strong, and it can even be said that in the long term, the trend will inevitably move in this direction. Since the long-term price of gold is bound to increase, shorting gold is going against the long-term trend. This mentality of trying to make a quick profit in the short term is not rational.

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