On Gold’s Relationship to Quantitative Easing

By John Banks

For a whole host of reasons, the gold price is hitting new all-time highs this week. This is happening in “nominal” terms, meaning not adjusted for inflation.

To reach a new inflation-adjusted high, and break the 1980 ceiling once and for all, gold will have to challenge the $2,500 per ounce level. At the rate things are going, that could happen soon enough.

We’ll have plenty more to say on gold in the coming days. We will also explain why gold’s next move from here could be explosive, due to what some are calling “the mother of all short squeezes” on the physical delivery side.

But first, an interesting question on the relationship between gold and quantitative easing (QE):

I’ve been wondering why, after major quantitative easing events, the dollar seems to gain strength and then lose value thereafter. And also, why gold seems to rise/peak and then start to lose value around such events.

I understand why after major quantitative easing events gold rises in value, but why does gold not maintain its value (within a reasonable margin) rather than experience a significant drop (as appears to be the case when it peaked in 2011)…

This will be a fun one to answer. (Admittedly, we have a strange idea of “fun.”)

The first thing to note is that gold does not respond to “quantitative easing” per se. It responds to expectations. The way that gold responds could be entirely different in one situation versus another.

To put it another way, there is no direct relationship between gold and QE. Instead, gold responds to changes in the market landscape, and QE operations are just another factor shaping that landscape.

Why did gold peak in 2011? That is a great question.

There is no definitive answer to the question. Different analysts will have different opinions. It isn’t like an engineering problem or a mechanical issue, where “A” can be identified as the cause of “B.”

Instead, you have to look at the myriad inputs of a complex system to figure out which combination of inputs led to what outcome. The challenge of doing this, and the inability to ever have a definitive “case closed” verdict, helps explain why analysts and historians can, and do, disagree on explanatory causes for almost everything, even historical events long after the fact.

With that said, in our view, gold’s 2011 peak can be attributed to the following factors:

  • By 2011, gold had already risen for 10 years straight, for a nearly 600% gain. The gold price bottomed out around $260 per ounce in March of 2001. It then proceeded to rise in value seven-fold from the March 2001 low to the September 2011 peak — roughly a 600% gain!
  • Gold’s decade-plus rise from 2001-2011 was pricing in “easy money” central bank policy. In the late 1990s, the dollar was super-strong due to all the capital flowing into tech stocks. After the tech bubble burst, Federal Reserve Chairman Alan Greenspan switched to an easy money policy, which Federal Reserve Chairman Ben Bernanke continued. Gold steadily discounted the impact of that policy — for a full decade.
  • When the Federal Reserve dramatically expanded its balance sheet in 2008, there were expectations for runaway inflation — which never happened. After the 2008 financial crisis, when the Federal Reserve added trillions to its balance sheet for the first time, inflation hawks expected runaway inflation to follow. It didn’t happen, for various reasons we’ll explain. Gold peaked in 2011, in part, on the realization that QE was not creating inflation (except in asset prices).

In terms of personal takeaways, the biggest one might be “don’t assume a mechanical relationship — instead, look at the situational context.” If the situational context is different, the outcome may well be different.

Then, too, the whole topic of Quantitative Easing (QE) is confusing and filled with misconceptions.

The act of QE is not actually “money printing,” for example, and it doesn’t cause inflation automatically.

Think of what would happen in this scenario: The Federal Reserve sends a trillion dollars to the banks, but the banks put the money in a digital vault. There is no lending, and no spending, as a result of the extra trillion in reserves — it just sits in the vaults like a pool of stagnant water.

How would those funds cause inflation? The answer is they wouldn’t.

Adding to the currency supply, via bank reserves, does not automatically create inflation. You need one of two things to get inflation: Either an accelerated run of lending and spending that drives prices up via competitive demand, or a loss of faith in the currency as such that holders of the currency want to get away from it.

In 2011, the market seemed to realize two things.

First, the market realized the huge wave of inflation expected from the Fed’s post-2008 balance sheet expansion was not going to happen.

That expectation was, in itself, a mistake, for the reasons we just explained. You don’t get inflation just from adding to bank reserves. There has to be real-world movement that translates to a pick-up in “monetary velocity” (the speed at which money changes hands).

Second, by 2011 the market realized that central bank policy was driving stock prices up, and that this steady drip-drip higher in stock prices was likely to last for a while.

The Fed did not create real-world inflation, in other words, but it did help with asset inflation — a steady increase in stock prices and stock valuation multiples. Here is how that worked:

  • The Federal Reserve supplied the banks with plenty of reserves while maintaining Zero Interest Rate Policy (ZIRP).
  • The banks used their ample reserves to lend large sums of money to blue chip corporations at very low interest rates. 
  • Blue chip corporations used the super-cheap borrowed funds to buy back shares en masse, which created the appearance of an improvement in earnings-per-share (because the same amount of earnings, spread across fewer shares, means higher earnings per share).
  • This virtuous circle of cheap funds fueling share buybacks causes the stock market to rise, in response to which corporations borrowed even more, to buy back more shares.

Against this backdrop, it is clear why gold peaked in 2011.

The market realized that real-world inflation was not on the way, but asset price inflation in the stock market was likely to continue, because the Fed’s actions were not helping the real economy much, but they were, in fact, juicing the stock market (by providing ample cash for stock buybacks at near-zero rates).

Given that backdrop, the natural play was to sell gold and buy stocks instead. The U.S. dollar also strengthened in this window of time because, from 2011 onward, the United States was more of a “safe haven” than other countries — Europe was in terrible shape, China was a question mark — and so global capital flows favored U.S. Treasuries, which in turn helped strengthen the U.S. dollar.

So, as you can see, when looking back at 2011, we can’t just think about gold’s relationship to QE. We have to look at gold’s relationship to everything, including the context of the gold price itself (which was coming off a historic 10-year bull run).

Here and now, in 2020, gold is at new all-time highs, and the Federal Reserve is once again engaging in aggressive quantitative easing operations.

And yet, once again, the Fed’s QE operations are only one factor among many. As with the situation in 2011, we have to look at the whole context.

Here are some factors to consider in the here and now:

  • Gold is coming off a multi-year rounding bottom. The gold price basically consolidated in a rounding bottom mode between 2011 and 2020. This points to a new multi-year bull run ahead, which could last for five to ten years. If price appreciation is comparable to the 2001-2011 move, the gold price could break $10,000 per ounce before all is said and done.
  • U.S. Treasuries are historically unattractive. Treasury yields are barely above zero, real yields are negative, and general expectations are that real yields (the nominal yield after inflation) will remain negative for years. This is a horrible outlook for Treasuries, and thus the U.S. dollar too, and a fantastic one for gold.
  • Trillions more in “helicopter money” — government fiscal support — is coming. The general consensus is that, as the national debt explodes, the U.S. government is just getting started. Trillions more will be coming — and we are talking about direct payments to households, at a time when supply chains for essential goods are constrained or broken. That’s inflationary.
  • The Federal Reserve is in serious danger of losing control. For reasons we will articulate more fully later on, we think Jerome Powell is at risk of going down in history as the Federal Reserve Chairman who accidentally destroyed the U.S. dollar. Buyers of haven assets, like gold and Bitcoin, are well aware of the dangerous dynamics here.

Another aspect to the question was interesting. Repeating an excerpt below:

I understand why after major quantitative easing events gold rises in value, but why does gold not maintain its value (within a reasonable margin) rather than experience a significant drop…

Note that, perhaps, your prior understanding is now modified.

After 2008, “QE” was bullish for stocks but not for gold, for reasons that were related to the specific situational context.

But moving on, the question “why does gold not maintain its value” also needs a rethink.

In a very real sense, gold has maintained its value in a manner more stable than any other asset in the history of mankind — and that still holds true today.

Gold has been a “store of value” for literally thousands of years, while various currency regimes come and go. The Bretton Woods regime lasted just over a quarter-century, from about 1945 to 1971, before Nixon trashed it. The U.S. dollar has been the world’s reserve currency for more than 70 years, but that is likely a temporary arrangement, too.

And yet, gold is primarily priced in dollars. That means, when the value of the dollar moves around, the value of gold (as priced in dollars) will change by default.

There is no way for the price of gold to be stable in dollar terms, in other words, because the perceived value of the dollar moving up and down is going to make the dollar-denominated gold price move up and down.

Then, too, gold is widely perceived as a form of crisis insurance. Gold is what you want to own when the world is falling apart, or when central bankers are losing the plot, or when the financial system is coming apart at the seams, or all three.

In its role as a form of crisis insurance, gold thus has a kind of uncertainty premium built into its price.

When uncertainty levels are high, the uncertainty premium built into the gold price will be high, and gold will be more expensive due to high demand.

When uncertainty levels are low, however — when investors are feeling fine, and real yields are healthy, and the central banks seem to have things under control — the uncertainty premium will also be low, and the gold price will reflect that lack of interest.

And so, in a very real way, it is not just the price of dollars that moves around relative to gold. It is the whole world that moves around.

Meanwhile gold, this super-stable asset that never rusts and never gets used up, just sits there as a ballast against all the craziness that is going on.

Now to give the final answer to an implied question: What is going to happen to the gold price from here?

Given the state of the world — and what is ahead for the coming decade — we think the gold price is going up, and up, and up.

If gold hits $10,000 per ounce between now and 2030, we would honestly not be surprised. And Bitcoin could exceed that by an order of magnitude.