Carlyle: Gold as The Currency of Last Resort

Authored By Jeff Currie for Carlyle

By nearly every known valuation metric for gold prices - inverse of real rates, the US dollar and marginal costs - gold and precious metals have disconnected from fundamentals to the upside. Yet most analysts, including us, continue to recommend an overweight allocation in gold and precious metals. Why? Gold is a direct alternative to fiat currencies in times of policy-induced currency debasement and systemic risk; hence, we call it the currency of last resort. A position it has held for three millennia versus 16 years for cryptocurrencies. Gold can survive nearly anything and its position on the periodic table gives it an infinite half-life, making it the ultimate monetary refuge in times of distress.

We believe gold is being driven by three factors - Debasement concerns, De-dollarization and portfolio Diversification. Each is becoming increasingly important for investors to consider when making asset allocation decisions. For example, gold reversed a sell off last week on news of fresh, yet more aggressive sanctions on Russia that threatened secondary sanctions on anyone dealing with Russian oil companies. Such secondary sanctions could be very disruptive to global payment systems, reinforcing further de-dollarization demand for gold.

During the Global Financial Crisis (GFC) confusion peaked over what was driving gold prices. Commentators attributed gold's rise to inflationary and deflationary concerns. Clearly, it can't be both at the same time, so was gold really an inflation hedge which was the prevailing view at the time? No. Debasement can occur with or without CPI-style inflation; what matters is the decline in real rates. Before the GFC, falling real rates were invariably associated with CPI-style, or what we like to call physical inflation. What we now know is that the dollar was being debased against inflation in financial assets like stock and bond prices, not physical inflation.

This characterization of gold worked well even through Covid when currency debasement was driven by both financial and physical inflation. This debasement reason for holding gold is typically captured in declining real rates and a weaker US dollar (see Exhibit 1). In fact, the term debasement comes from when the Romans would mix 'base' metals like copper into precious metals like gold, to 'debase' their gold coins. This characterization of gold worked extremely well until 2022 when gold sharply disconnected from real rates, driven by a new force: de-dollarization.

In 2022, gold prices sharply disconnected from US real rates when the Western powers froze around $300 billion of the c.$600 billion in Russian central bank's assets. Although the communication was very clear in 2022 that the West would respect international law and not touch the assets, very few emerging markets (EM) central banks believed Western policymakers and began to sell US treasuries reallocating to gold to hedge themselves. Clearly, that decision proved prescient with German Chancellor Merz recently advocating to use frozen Russian central bank assets to back financial aid for Ukraine. Historically, countries whose central bank assets are frozen -such as Iran, Venezuela, North Korea, Afghanistan and Libya -rarely recover economically. Only Iraq, following an absolute regime change, has re-emerged from this in the post-war era, though fragility remains. In other words, it must be avoided at all costs. "Fool me twice, shame on me."

This shift led to a simultaneous surge in central bank gold holdings and a reduction in US Treasuries. In early September of this year at $3,500/toz, gold surpassed US Treasuries, and today at $4,200/toz price gold has a 27% share of central bank reserves compared to US treasuries at 23%. To put this in perspective, in 1970 before the Nixon Shock, when Nixon took the US dollar off the gold standard, gold's share was 40%, suggesting further room to run.

But as you can see in Exhibit 2, the rise in EM central bank demand for gold started well before 2022, which highlights why US administration recently only threatened secondary sanctions on those who transact with Russian oil companies. This current de-dollarization trend initially started in 2018 when Trump 1.0 imposed secondary sanctions on Rusal, the Russian aluminium producer, for Russian tampering over US political elections. Russia responded by aggressively starting the de-dollarization process by selling nearly $100 billion in US Treasuries and replacing them with gold and physical greenback currency.

In that same year, after a pilot program in March 2018, China launched CIPS (Cross-Border Interbank Payment System) to compete with the US's SWIFT system. While CIPS only manages around 2-3% of global payment flows by value, it now processes nearly all cross-border renminbi clearing, particularly in the oil trade. The key to how big of a supply disruption in Russian crude this recent round of sanctions can create is how willing Indian and other EM oil refiners are willing to go all in into the CIPS payment system. This is likely a one-way revolving door.

Even the Talmud advises to: "let every man divide his money into three parts… and a third kept by him in reserve." This "reserve" is commonly interpreted as gold and silver, representing security against uncertainty.

However, given the outperformance of the Magnificent Seven in the US equity market over the past decade, portfolio allocators found they could be underweight many assets like commodities and old-economy companies if they maintained an overweight in US Big Tech. As gold prices rise, underweight investors risk underperformance and are compelled to buy it even at lofty levels. This type of demand extends to gold miners and even to central bank reserves as institutions seek to maintain balance sheet strength. This is a dynamic we are likely to see in other assets that were neglected during the search for yield environment.

At today's prices, the current global stock of gold holdings is around $30 trillion, compared with the total market capitalization of $2.6 trillion for Bitcoin and $3.8 trillion for all cryptocurrencies combined. Importantly, gold's enduring value is underpinned by real world utility, like jewellery demand. This provides a floor to its price which softens price swings from investor sentiment. In contrast, Bitcoin doesn't have such real-world utility, which is why it's extremely volatile and less reliable as a store of value. However, not all cryptocurrencies are created equal. Ethereum does have real world applications, much like gold, in the form of smart contracts. But with a $780 billion market capitalization, Ethereum has a long way to go, and unlike gold, it doesn't have an infinite half-life. Buy gold as your hedge against debasement, de-dollarization and to provide diversification.