Geopolitical Risks Enhance Gold’s Role as a Reserve Asset
- Central banks have ramped up gold purchases driven by de-dollarization,7 the need to diversify reserves and hedge against inflation, and gold’s emerging role as a neutral reserve asset.
- While central banks are buying gold at a record pace, investment selling has reached exhaustion levels.
- As deglobalization accelerates, de-dollarization is becoming more relevant and is being exacerbated by the weaponization of the U.S. dollar and rising U.S. political risk.
- Central banks hold gold as a neutral reserve asset to mitigate increasing counterparty risks amid escalating geopolitical tensions.
- The projected increase in net issuance of U.S. Treasury securities in the second half of 2023 may lead to liquidity challenges. This could cause dysfunction in the market, including asset price declines, tightening liquidity and further pressure on the U.S. banking system.
Month of May 2023
|Mo % Chg
|YTD % Chg
|Short-term price volatility on debt ceiling opera
|Similar to Feb low-liquidity pullback
|NYSE Arca Gold Miners (GDM)3
|Pullback to support on thin volume
|Bloomberg Commodity Index (BCOM)4
|Weak China data and growth concerns
|DXY US Dollar Index5
|Moved higher on debt ceiling liquidity concerns
|S&P 500 Index6
|Extremely narrow market
|U.S. Treasury Index
|Fed rate hike expectations turning higher
|U.S. Treasury 10 YR Yield*
|Core inflation data sticky
|U.S. Treasury 10 YR Real Yield*
|Real yields backing up to near highs
|Gold ETFs** (Total Known Holdings ETFGTOTL Index Bloomberg)
|Slight increase despite gold price decline
|Silver ETFs** (Total Known Holdings ETSITOTL Index Bloomberg)
|Slight decrease; flat since Q4 2022
Source: Bloomberg and Sprott Asset Management LP. Data as of May 31, 2023.
*Mo % Chg and YTD % Chg for this Index are calculated as the difference between the month end's yield and the previous period end's yield, instead of the percentage change. BPS stands for basis points. **ETF holdings are measured by Bloomberg Indices; the ETFGTOTL is the Bloomberg Total Known ETF Holdings of Gold Index; the ETSITOTL is the Bloomberg Total Known ETF Holdings of Silver Index.
May in Review
Spot gold fell $27.27 per ounce (-1.37%) in May to close the month at $1,962.73. The gold price peaked in early May before drifting lower while the U.S. debt ceiling drama deepened and the U.S. dollar surged as market liquidity faded. Commodities fell sharply when weaker-than-expected economic data from China coupled with the spike in the U.S. dollar produced a wave of selling in a liquidity vacuum. In an environment with low liquidity and a rising U.S. dollar, riskier and less liquid assets ("high beta") such as gold miners and physical silver had a much sharper pullback.
At the same time, the broader equity markets continued to display unusual activity. In early March, signs of a slowing economy led to expectations of cooling inflation and the end of Federal Reserve (Fed) tightening. This sparked a rally in long-duration assets, especially mega-cap technology stocks. Near the end of May, a dot-com-like frenzy occurred in AI (artificial intelligence) related equities, further accelerating and narrowing market breadth to a half-dozen stocks. In contrast, the equal-weighted S&P 500 Index (SPW)8 fell 3.99% in May (-1.43% year-to-date as of May 31, 2023), more reflective of the overall equity market.
Gold Continues to Consolidate Gains
In May, spot gold reached an intraday level of $2,063, just below the March 2022 intraday high of $2,070. The gold price then fell and tested the rising trendline from the November 2022 low and its 100-day moving average (Figure 1). A thin market saw mainly CFTC9 futures traders active as gold held in ETFs (exchange traded funds) increased slightly. There was no indication of selling from central banks or sovereigns.
Gold appears to be consolidating its gains from the autumn 2022 lows as there is very little selling pressure — only about five million ounces from CFTC longs during May's pullback (Figure 2, lower panel). CFTC shorts remained inactive in May and gold in ETFs continued to trend higher, albeit at a modest rate.
Figure 1. Gold Tests Resistance and Support (2021-2023)
Source: Bloomberg. Gold bullion spot price, USD/oz. Data as of 6/05/2023. RSI = relative strength indicator, a momentum indicator that measures the speed and magnitude of price changes to evaluate overvalued or undervalued conditions. In the lower panel, the area above the red line indicates buying pressure or overbought conditions, while the area beneath the green line indicates selling pressure or oversold conditions. Included for illustrative purposes only. Past performance is no guarantee of future results.
Figure 2. Minimal Selling Pressure (2022-2023)
Source: Bloomberg. Gold held in ETFs and CFTC non-commercial longs and shorts in millions of ounces. Data as of 6/06/2023. Included for illustrative purposes only. Past performance is no guarantee of future results.
Central Banks and China Drive Demand, Investment Flows Fall
1. Central Banks Maintain Buying Pressure
Net quarterly gold purchases by central banks rose by 243 tonnes in Q1 2023, a continuation of the robust buying trend that began at the end of last year's second quarter (Figure 3). Since Q3 2022, central banks have been buying at an annualized rate of 1,456 tonnes, nearly three times their previous annual rate of 506 tonnes.
We have discussed the reasons for aggressive central bank buying in our past commentaries, most recently in the February 2023 commentary (“First Gold Dip Since Central Bank Buying Spree”). These reasons include the urge to diversify reserves due to sanctions and seizure risk, a need/desire for "outside money" in central bank reserves, the trend of U.S. dollar weaponization and de-dollarization, a need to hedge against inflation effects on global currencies and sovereign bonds in central bank reserves, and protection from escalating geopolitical tensions due to deglobalization.
We can add another possible reason to the list: Counterparty risk for sovereigns with large commodity exposures which we explore later.
Figure 3. Central Banks Continue to Build Gold Reserves (2013-2023)
Source: Bloomberg. Net quarterly gold purchases by central banks in tonnes. Data as of 6/05/2023. Included for illustrative purposes only. Past performance is no guarantee of future results.
2. China Steps Up Gold Imports
Gold demand from China continues to trend positively across all sectors. We show China's gold imports plotted against central bank purchases in Figure 4 to demonstrate the scale of China's gold imports. The steep decline in imports from 2020 to 2021 was due to China's extensive and extended COVID pandemic lockdowns, which are unlikely to be repeated. Other positive gold data points out of China include:
- The average Shanghai gold premium10 has been trading above its 10-year mean since October 2022.
- Gold reserves held in the People's Bank of China (PBOC) have increased every month since October 2022 to a new all-time high of 67.3 million ounces or 2,092 tonnes as of May 31.
Figure 4. China's Gold Buying Outpaces Central Banks (2018-2023)
Source: Bloomberg. Rolling 12-month gold purchases, metric tonnes. Data as of 5/31/2023. Included for illustrative purposes only. Past performance is no guarantee of future results.
3. Investment Demand Slumps
We believe that we are in the early stages of gold becoming less of a financial asset and more of a neutral reserve asset, as witnessed by the remarkable surge in central bank sovereign gold purchases. Figure 5 highlights the stark increase in gold buying by central banks versus CFTC and ETF investment flows, which are close to their typical low readings since 2018. This indicates that gold investment selling is likely at an exhaustion level. The gap between central bank buying and investment selling has reached a record high of 1,800 tonnes, indicating how far this divergence has gone. Given this, we believe that investment flows will likely be forced higher.
Figure 5. Investment Flows Near Exhaustion (2016-2023)
Source: Bloomberg. Rolling 12-month net gold purchases by central banks, and CFTC and ETF gold investment flows, metric tonnes. Data as of 5/31/2023. Included for illustrative purposes only. Past performance is no guarantee of future results.
The Long and Winding Road to De-Dollarization
Deglobalization is accelerating the transition to a more multipolar world, making the question of global reserve currency allocations more relevant. The U.S. dollar has slowly lost market share as a reserve currency since its peak in the late 1990s (Figure 6). History has shown that currency predominance in international trade and reserves follows economic, cultural and military dominance. Currency reallocations could move more quickly and significantly than anticipated if reserve managers increase allocations to other currencies or reserve-neutral assets. If reserve managers were to reallocate a small percentage of reserves, significant flows out of the U.S. dollar could occur because the dollar base is so large.
Currently, the risk is minor and gradual, but China has the potential to gain share as its reserve share (~2%) is lower than what is implied by its share of global gross domestic product (GDP; ~15%), global trade (~12%) and the International Monetary Fund (IMF) Special Drawing Rights (SDR)11 basket (10.9%). China has made structural changes to its financial markets to improve access and gain inclusion in global benchmark indices. However, substantial reforms are needed to increase the renminbi (RMB) as a reserve currency.
Increasing the use of the RMB in China's import invoicing (for example, paying for oil in RMB) could present an opportunity for more significant global use of the RMB. Globally, foreign exchange reserves are estimated to be $12 trillion in total, which means that tiny incremental percentage changes at the margin would represent large U.S. dollar values.
The U.S. dollar is expected to remain the anchor currency for the foreseeable future due to its established base, provision of safe assets, inflows and foreign exchange strength, and perceived safety. However, the weaponization of the U.S. dollar continues to be the most substantial non-economic rationale for de-dollarization. A default over the U.S. debt ceiling would have presented another strong argument for further de-dollarization since an investment in U.S. Treasuries (or their use as collateral) would entail direct exposure to U.S. politics.
Figure 6. U.S. Dollar Losing Global Reserve Share (2016-2022)
Source: International Monetary Fund. U.S. dollar as a percent of global foreign exchange reserves. Data as of 12/31/2022. Included for illustrative purposes only. Past performance is no guarantee of future results.
Rising Geopolitical Risk is Bullish for Gold
Counterparty risk is the potential for one party in a financial transaction to default on its contractual obligations. Geopolitical factors can significantly influence counterparty risk, impacting the stability and reliability of parties involved in a financial transaction. If one party fails to fulfill its obligations, the other party may suffer financial harm.
Counterparty risk can show itself in various forms, including credit risk stemming from financial distress, settlement risk involving the failure to deliver, sovereign risk linked to government defaults, and legal and operational risks encompassing fraud and disputes. Standard risk mitigation practices include imposing collateral requirements, implementing margining practices, using central counterparties for clearing and settlement, making credit assessments and diversifying exposures.
Default risk has been the most prevalent historically. However, other risks (settlement, sovereign, and legal/operational risks) could all trend higher in a deglobalizing world with escalating geopolitical tensions.
As gold becomes increasingly involved in settling multicurrency energy and commodity trades — particularly in China-related trade with oil producers — the links between gold, other commodities and counterparty risks may intensify. The recent trend to nationalize commodities amid concerns over deglobalization and national economic security is likely to escalate counterparty risk on a global scale. Sovereign gold held by a country's central bank as a neutral reserve asset could mitigate this risk. This may drive increased demand for sovereign gold to hedge against inflation by nations with high exposure to commodity markets.
Because of these factors, we believe gold is moving incrementally back into the financial system as a neutral reserve asset to settle multicurrency energy and commodity trades. Given that the global oil trade alone is ~15x the size of the gold market, we believe this is secularly bullish for gold.
Market May Struggle to Absorb U.S. Treasury Issuance
The U.S. fiscal deficit is expected to reach approximately $1.1 trillion in the second half of 2023, a fallout from the debt ceiling standoff. An additional $400-$500 billion will be needed to rebuild the Treasury General Account (used to pay the country's obligations), and $540 billion will be required for the Federal Reserve’s quantitative tightening program. This would result in a significant net U.S. Treasury (UST) issuance of approximately $2 trillion during the second half of 2023.
The U.S. could face challenges in finding sufficient global demand to absorb this level of issuance, given its high debt level and budget deficits alongside insufficient foreign central bank buying. This could lead to asset price declines, rising yields and potentially a credit crunch. UST market dysfunction could increase again, as measured by the MOVE Index (implied bond volatility index)12 and the Bloomberg U.S. Government Securities Liquidity Index (Figure 7). We recommend keeping an eye on these two indices in the second half of 2023.
There is potentially a lack of private sector balance sheet capacity to finance the expected UST issuance. A starting point of higher interest rates may further exacerbate U.S. deficits and reduce private sector output while keeping inflation, employment, and nominal GDP relatively high. A capital crunch is possible as various sectors compete for limited capital.
Significant liquidity tightening would increase yields and pressure on the U.S. banking system and financial assets. Rising yields may increase capital flow into money market funds, leading to flows into the overnight reverse repurchase agreements market (ON RRP).13 This may drive up the borrowing costs of the U.S. Bank Term Funding Program,14 squeezing bank profitability further and increasing regional banking stress. In summary, less liquidity means less cash to inflate financial assets and higher credit risks.
For gold, the risk elements listed above (liquidity risk, credit stress, credit crunch, U.S. Treasury market dysfunction, bond volatility, inflation and regional banking stress) have been historically bullish for gold prices. But we are unaware of prior episodes when all these elements have converged in a narrow window of two quarters. Furthermore, if central banks and sovereigns maintain their pace of gold purchases into the second half of 2023, the potential for a squeeze higher for the gold price may likely increase.
Figure 7. More Dysfunction Ahead for U.S. Treasury Market? (2013-2023)
Source: Bloomberg. Bloomberg U.S. Government Securities Liquidity Index (top panel) and MOVE Index, a gauge of interest rate volatility in the U.S. Treasury market (bottom panel). Data as of 6/7/2023. Included for illustrative purposes only. Past performance is no guarantee of future results. You cannot invest directly in an index.
|Gold bullion is measured by the Bloomberg GOLDS Comdty Spot Price.
|Silver bullion is measured by Bloomberg Silver (XAG Curncy) U.S. dollar spot rate.
|The NYSE Arca Gold Miners Index (GDM) is a rules-based index designed to measure the performance of highly capitalized companies in the Gold Mining industry.
|The Bloomberg Commodity Index (BCOM) is a broadly diversified commodity price index distributed by Bloomberg Indices.
|The U.S. Dollar Index (USDX, DXY, DX) is an index (or measure) of the value of the United States dollar relative to a basket of foreign currencies, often referred to as a basket of U.S. trade partners' currencies.
|The S&P 500 or Standard & Poor's 500 Index is a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies.
|De-dollarization refers to countries reducing reliance on the U.S. dollar as a reserve currency, medium of exchange or as a unit of account.
|The S&P 500 Equal Weighted Index (Bloomberg Ticker: SPW) is the equal-weight version of the widely-used S&P 500. The index includes the same constituents as the capitalization weighted S&P 500, but each company in the S&P 500 EWI is allocated a fixed weight - or 0.2% of the index total at each quarterly rebalance.
|Shows the positioning of speculative investors in the U.S. gold futures markets as reflected in the weekly “commitment of traders” report from the Commodity Futures Trading Commission (CFTC), a U.S. government agency. This is used as an indicator of market sentiment for the price of gold.
|The Shanghai gold premium measures the difference between reference prices on the Shanghai Gold Exchange and the LBMA Gold Price, the global benchmark price for unallocated gold delivered in London, in US$/oz.
|The SDR was created by the IMF in 1969 to supplement other reserve assets of member countries. Its value is based on a basket of five currencies: the U.S. dollar, the euro, the Chinese renminbi, the Japanese yen and the British pound sterling. The SDR itself is not a currency but an asset that holders can exchange for currency when needed.
|The MOVE Index calculates the future volatility in U.S. Treasury yields implied by current prices of options on Treasuries of various maturities.
|The U.S. Federal Reserve uses the overnight reverse repurchase agreement (ON RRP) facility as a supplementary policy tool to manage the Federal funds rate. When the Fed conducts an overnight RRP, it sells a security to an eligible counterparty and simultaneously agrees to buy the security back the next day. This effectively gives participants in the short-term funding market the option of leading to the Fed risk-free overnight at the guaranteed ON RRP rate.
|The Bank Term Funding Program (BTFP) was created to make additional funding available to eligible depository institutions. It offers loans of up to one year to banks, savings associations, credit unions, and other eligible depository institutions pledging any collateral eligible for purchase by the Federal Reserve Banks in open market operations.
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