The following factors may cause the price of gold to drop substantially.

  • Gold price manipulation
  • Gold confiscation
  • Positive real interest rates
  • Strengthening fiat currency
  • Alternative currency

Every investment has its risks and there’s no such thing as certainty when it comes to the markets. It is therefore really important to look at investments from all angles so that you are fully informed of the risks and that will also help you determine the degree of asymmetry of the trade.

Gold price manipulation

Manipulation this is a topic that a lot of people love to talk about and some get wound up with red faces and steam coming out of their ears. All markets are manipulated to some extent and precious metals are no exception. Having said that, manipulation can occur in either direction, so prices can just as easily be manipulated upwards as downwards. We don’t really have any way of knowing when that switch in direction is going to occur. Yes, manipulation of the paper price of gold is a risk and it is one that we must bear in mind. However, just because the paper price of gold is suppressed it doesn’t necessarily mean that the physical price will also get dragged down with it. Episodes where a disconnect between the paper and physical price of gold and silver have been observed in the past.

Gold confiscation

Gold confiscation is a risk for gold investors. Confoscation my occur in a few ways. Illegal confiscation (also known as theft) is one obvious form. If you store your physical gold in a bank-owned storage facility, that is going to be at risk in the event of a bank bail-in. This risk may be avoided by storing your physical precious metals in a non-bank facility. Another form of legal confiscation my be carried out by the government and that can occur in two ways. It could occur directly as occurred in the 1930s when people were threatened with jail if they didn’t comply. Although it is possible that this could occur in the future, the probability seems low. However, what is much much more likely to occur is confiscation via taxation. This is probably the biggest risk of all for gold owners. What is there to stop the government from slapping a 90% tax on all bullion sales?

Positive real interest rates

An important factor in driving the gold price is real interest rates. The real interest rate is the nominal interest rate minus inflation. Notably, the real interest rate is highly negatively correlated to the gold price (correlation coefficient of -0.89).

US real interest rate vs gold price (Source: FRED)

Whenever the real interest rate (shown in blue in the chart above) moves in a positive direction, the gold price (yellow line) moves downwards and vice versa. Recently, there was a very sharp spike upwards in the real interest rates and, as expected, that was associated with that spike downwards in the price of gold. Since then we have seen real interest rates go deeply negative and it went below -1% recently. That coincided with a rise in the gold price.

An upwards move in the real interest rates is therefore a risk for gold investors. The scenarios in which this might occur include a case where for instance the nominal interest rates remain static or go lower and we also get deflation. Another possible scenario is if the federal reserve lost control of interest rates resulting in a rise in the nominal interest rate. However, if the inflation rate also remains low, that combination would also cause real interest rates to go up. Significantly positive real interest rates seem quite unlikely (See “The trigger for the next commodies boom”). It is more likely that real interest rates go deeply negative.

Strengthening fiat currency

A decrease in the currency supply would be negative for the gold price. We have a real world example of this during the US civil war when the government issued a fiat currency called the greenback. This was legal tender and was not backed by gold.

Gold price during the US civil war (Source Civil war chat)

As greenbacks were issued in increasing volumes between 1861 and 1865, the above chart shows that the gold price rose substantially, reflecting devaluation of the greenback. At the end of the war in 1865 the US treasury sold their gold in exchange for the issued greenbacks until all of the dollars had been redeemed. That caused the large drop in the gold price at that time. The chances of currency deflation in this day and age seems very remote given that the printing machines are in full swing and the chances of printed currencies being repaid in gold seem very slim.

Another argument for potential weakness in the gold price is the dollar milkshake theory put forward by Brent Johnson. His theory centers around the idea that the demand for US dollars will exceed the supply, causing the US dollar to strengthen significantly. The milkshake is made up of all the printed currencies from the global central banks and the straw that sucks the liquidity out of the system includes foreign countries and companies that need US dollars to pay off dollar denominated debt and interest. That would be further exacerbated by Federal Reserve tightening. This is quite a complex topic because there’s so many moving parts and it is certainly worth listening to Brent and some of the debates that he has had with others. There are so many factors that can affect this theory and we do have reason to believe that a spike in the US dollar index can affect the gold price.

Correlation between the Dollar index (DXY) and gold price

The chart above shows the US dollar index (DXY) in bars and the gold price (yellow line) over the last 40 years. When we compare the significant spike in DXY to the gold price in the late 1970s/early 1980s, DXY rose by 98% and the peak to trough price drop for gold at that time was 55%. I the DXY spike of the late 1990s the US dollar index rose 51% and the price of gold fell by 36%. More recently, the US dollar index rose 43% and gold price dropped 45%. In general. most of the time, DXY and gold price are negatively correlated. It is interesting to note that the correlation was actually positive over the past year but it has slipped back into negative territory. Overall, this chart suggests that if we do get a spike in the US dollar index, chances are the gold price will drop (unless the correlation becomes positive again). Another interesting point about this chart is that over the last 40 years the peak of the DXY spikes have become successively lower. Does that suggest that the next spike will be lower still?

Care should be taken around the term “US dollar strength”. The US dollar index compares the US dollar to a basket of other currencies and is heavily weighted towards the euro.

CurrencyWeighting
Euro57%
Japanese Yen14%
British Pound11%
Canadian Dollar9%
4Swedish Krona4%
Swiss Frank4%
Composition of the US dollar index (DXY)

All the currencies that make up the DXY are fiat currencies and so we’re basically comparing crappy pieces of paper with each other. When we say that the US dollar is strong, it just means that it’s less crappy than the other currencies. What really matters is the purchasing power. If your goal is trading forex, then yes, these spikes in DXY do matter. However if your goal is wealth preservation then actually it’s the purchasing power that you want to look at.

DXY vs purchasing power of US dollar (Source: FRED)

In the chart above, if we compare the US dollar index at the top to the purchasing power of the US dollar over the same time period, you can see that they look very very different. Spikes in the US dollar index are not associated with spikes in the purchasing power. In fact the purchasing power just continuously keeps dropping.

Purchasing power of gold vs US dollar

If we compare the purchasing power of gold to that of the US dollar (chart above), we can see that in the pre-fiat era both move together. The red line represents the start of the fiat currency era. After the red line, the purchasing power of gold has risen whereas the purchasing power of the US dollar has continued to decline. In a world where currency is being printed freely, a spike in the US dollar index and perhaps a short-term drop in the gold price doesn’t actually matter if your aim is the preservation of wealth and purchasing power.

Alternative currencies

Historically when a currency has failed or is failing, a brand new currency is rolled out. Whenever a failed fiat currency is replaced with another fiat currency, that second currency usually fails rapidly. In the event that one of the current fiat currencies gets replaced by a government-run digital fiat currency, that isn’t necessarily detrimental to the gold price because the government is simply replacing one fiat with another.

The case with cryptocurrencies is a little bit different. The cryptocurrencies that are decentralized and not inflatable are effectively non-fiat. This is a very polarizing topic and is the subject of a lot of heated debate in the gold community but there is room for both gold and cryptocurrencies. Cryptocurrencies won’t necessarily be detrimental to the gold price per se.

Correlation between bitcoin and gold price

The chart above shows the bitcoin price on the monthly scale (bars) compared to the gold price (yellow line). The correlation coefficient is shown at the bottom of the chart in red. The correlation is generally moderately positive (approx +0.6) at the moment but bear in mind that this history is relatively short.

Correlation between bitcoin and DXY

In contrast when we compare the bitcoin price (bars) to the US dollar index (green line)(chart above) then we can see that they are more often strongly negatively correlated.

We can conclude that in general, bitcoin seems to move more in line with the gold price than it does with fiat currencies in terns of direction of movement.

Conclusion

Gold investment is by no means associated with certainty and there are risks associated with gold investment, some of which have been outlined here. Some of these risks are more likely to occur than others. None of us know for certain how things are going to pan out and so it is really important to understand what can go wrong and account for these possibilities when deciding on your portfolio allocation.