2025 has been an excellent year for an array of asset classes. The US Aggregate Bond Index has returned over 7%, the S&P is up nearly 12%, and bitcoin is 19% higher. Beneath the surface, trendy Artificial Intelligence (AI) names have led the way, such as Nvidia, which has rallied 34%. But the best returning asset is one that has been around for thousands of years: gold, which has risen over 50% year-to-date (YTD). The question we aim to answer is why has the yellow metal had its 2nd best calendar year performance in the last half century?
There are three traditional knee-jerk responses: gold is used as a hedge against inflation and dollar debasement (particularly if the Federal Reserve, Fed, may lose its independence), uncertainty, and recession. However, when we analyze these explanations, all three have problems. First, inflation expectations aren’t rising but instead remain well-anchored at 2.5%. Second, implied rates volatility, a tangential measure of uncertainty, has declined all year and is now at the lowest level since 2021. Lastly, with stocks near all-time highs and credit spreads at multi-decade tights, it’s difficult to argue that the market is ascribing a high probability of recession.
Perhaps declining real yields have driven the rise in gold? Historically, as bonds have rallied, the opportunity cost of holding gold decreases and its price goes up. Indeed, when the Fed re-started rate cuts in September, gold began another leg higher, and, when combined with overwhelming momentum and looser financial conditions, it soared to new heights. Yet while these factors may explain the latest rally, if we examine this relationship further back in time, something broke in the early 2020s, which leads us to question whether there are additional factors at play.
The answer lies in the most fundamental form of commodity analysis: supply and demand. On the production side, unlike other commodities, gold supply is stable and inelastic; annual growth in above-ground stocks has been steady between 1.5% and 2.5% for decades1. And on the consumption side, demand is rising. What began as countries shifting their marginal dollars away from the US dollar2 and Treasuries has evolved into a more explicit transition toward gold. Whether this is due to a desire to diversify new holdings or an attempt to benefit from further gold price appreciation, reserve managers in China and other Emerging Market countries have been ramping up purchases, particularly in the last few months. Furthermore, the shift is happening among private investors as well, which can be seen in elevated ETF holdings. Combining these supply/demand dynamics with the fact that gold is an incredibly liquid market that represents only a 4% allocation of global AUM1, even a small rotation toward the asset class can have an outsized impact on prices.
Where do we go from here? The downside risks are driven by valuations. Gold has morphed from a fundamental trade into a momentum one, and these types of moves eventually run out of steam. However, there are also reasons to suggest the long-term equilibrium price may be above $4,000. First, Gold tends to rally after the Fed begins easing policy; over the past ten rate cutting cycles, gold has risen over the subsequent six months 80% of the time by an average of 11%. Second, reserve managers should continue buying, and ETF holdings will keep increasing as the world diversifies its exposure away from the US. Lastly, unless the US is able to alter its fiscal trajectory, concerns around debt debasement will continue to percolate, accelerating demand for the yellow metal.