In today’s Finshots, we dive into the meteoric rise in gold prices and what it could be telling us about the state of the world economy.

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The Story

Gold prices have been on a tear over the last year. Just 12 months ago, gold was trading at ₹58,000 per 10 grams. Today, it’s brushing up against ₹77,000. And this isn’t a one-off moment; it follows another solid rise in 2022 when prices stood at ₹50,000.

So, why is everyone suddenly eyeing gold again?

Well, gold has always been a bit dramatic, reacting to the world’s economic twists and turns. But this isn’t just any ordinary gold rally. It’s part of a bigger story that involves currencies, central banks, and a world economy that’s growing increasingly unstable.

Let’s start with gold’s long-time partner, the US dollar. You see, gold is a bit like oil. Globally, people buy and sell gold using the dollar. And this means the value of Gold is inextricably tied to the value of the dollar. Therefore, a weaker dollar makes gold appear more affordable for investors using other currencies. And that’s exactly what’s been happening. The dollar has lost ground, making gold more attractive and driving up its demand.¹

But the dollar weakening isn’t the whole story. There’s more, and it starts with the folks in charge of managing the world’s largest economy: the US Federal Reserve.

After hiking interest rates aggressively in 2022, the Fed finally hit pause in 2023. And recently, it did something it hasn’t done in four years. It cut rates. This had ripple effects. When interest rates drop, bond yields (the return investors get for holding bonds) fall too.² So, when bonds don’t offer much in the way of returns, investors look for alternatives. That’s where gold comes in. It doesn’t pay interest, but it’s a solid store of value. And when bonds aren’t delivering, gold shines as the safer bet.

Then there’s global inflation. Rising prices are eating into the value of currencies everywhere. Central banks have been printing money like there’s no tomorrow. But the more money that floods the system, the less valuable it becomes. And when that happens, investors turn to gold, the age-old hedge against inflation. Gold’s been a tangible, finite resource for centuries, and its value remains, even when paper currencies falter.

But you might wonder, don’t these factors always influence gold prices? Yes, they do.

So how do we know if this rally has legs and if gold is undervalued or overvalued?

A good place to start is by looking at central banks. In 2022, they bought a record-breaking 1,136 tonnes of gold—the highest in over 50 years. And in just the first half of 2024, they’ve added another 483 tonnes.³

Why the gold rush? Well, central banks are hedging against potential currency crises and inflation. They’re not just issuing money but they’re protecting themselves from its risks by increasing their gold reserves.

However, the problem with gold buying data is that it gives you just the number of gold purchased, without any comparison for analysis.

And that’s where money supply comes in.

The money supply, or the total currency floating around in an economy, has exploded over the last few decades. In the US, the broadest measure, the M2 money supply (which includes cash, checking deposits, and savings), has more than quadrupled since the early 2000s. Here’s a look:

US M2 Money Supply over the years

And gold has reliably tracked money supply growth for the last 50 years, according to the World Gold Council.⁴ Why? Two reasons: the US dollar is the global reserve currency, and gold is priced in dollars on most exchanges.

So, as more money floods the market, people lose faith in paper currencies. Gold, being a finite resource, holds its value and becomes the go-to asset for wealth protection.

Now, while a moderate rise in money supply is generally desirable, when it spikes too much, it spells trouble. A significant jump in M2 can indicate too much money chasing too few goods, which pushes inflation higher and erodes the value of currency and other assets. In these times, investors flock to safe-haven gold, and central banks might increase their gold reserves to shield themselves from the impacts of inflation.

If you want to take this analysis further, there’s something called the M2 to Gold ratio. It compares the price of gold to the money supply, giving us a sense of whether gold is under or overvalued.

And finally, we can’t ignore the US national debt, which has skyrocketed from $5.77 trillion in 2000 to an eye-watering $35 trillion today.⁵ As debt rises, the risk of economic instability grows, prompting more investors to hedge with gold.

So yeah, while the gold rally we’re witnessing lately can be attributed to various factors, the link between gold and money supply is an interesting one to follow.

It’s hard to say if gold will continue its rally, but the factors driving gold’s rise—the weakening dollar, inflation, central bank buying, and skyrocketing debt—aren’t going away anytime soon.

After all, this rally isn’t just about gold prices going up. It’s about what those rising prices are signaling. The world economy is in a precarious position, and gold is serving as a barometer for that uncertainty. This rally could be hinting at something much larger shift in the financial system as we know it.

Until then…

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Story Sources: Reuters [1], Morningstar [2], World Gold Council [3] [4], FiscalData [5]

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