In 2015 I introduced a model to explain the movements in the price of gold using just two variables: M2 and the broad dollar index. This simple model captures movements in the price of gold quite well, though could not very well explain the crash in gold prices a few years ago (as an aside, inflation expectations as measured through TIPS can explain this, though since these data do not go back very far in time I am hesitant to use this as a model). Since then, much has changed, especially in the dollar index which fell about 6% at its worst in 2016. While this has been getting most of the attention, changes in the money supply have been relatively understudied. In this article, the changes in the money supply will be examined, and an updated view of the M2 to Dollar Index model will be provided to predict where the price of gold should be.
Recent Changes in the Money Supply
One of the most famous measures of the money supply that gold bulls like to use is the monetary base. While very important, this has less influence on the short term price of gold because the entirety of the monetary base is not in circulation. In fact, recently most of that money has gone to excess reserves of banks. Being out of circulation, these reserves have not provided the inflationary pressure that many predicted (though just because they do not produce price inflation does not mean that they are not causing any distortion at all).
For years as the monetary base increased, the excess reserves increased as well, making the money in circulation rise at a steady pace. That seems to be changing now, though, as shown below.
Starting in 2016 we have seen rather large decreases in excess reserves. Year over year we are seeing values fall between 10% to 20%. This is very significant because many have predicted that if excess reserves spill out, that there will be significant price inflation. Since we are now seeing a sizeable sum of excess reserves spill out, does that mean inflation is right around the corner? Below is shown a graph of M2 to see the effect on money in circulation.
In 2016 we see something that has not happened in M2 for years. In this year over year percent change graph, notice the rise that is starting in 2016. We are seeing now acceleration in M2 growth, and the highest total M2 growth since 2013. This is a very bad sign for price inflation, especially if the acceleration continues. If excess reserves continue to spill out, the Fed may have no way to stop this.
M2 to Dollar Index Model
Click to enlarge This graph shows an updated M2 to Dollar Index plot (shown in blue) and the gold price (shown in red). There is a very tight relationship between the two which broke down in a large way a few years ago. Starting in 2016, we have seen gold go from nearly $1000 an ounce to more than $1300 an ounce in very short order.
This has seemed to be a reaction mostly to Brexit, but fundamentally we can see that gold still has a long way to go to catch up to where it should be. In addition, I have also argued that the dollar index is in a nasty bubble, which will provide even more tailwinds for gold in the near future.
GDP is one of the main props holding up the current dollar index valuation. If GDP cannot hold steady and sees any weakness, the dollar index will fall quickly, and we may be looking at $1800 gold in the near future, and that is without even considering any additional growth in M2! Right now, even without a dollar correction and without additional growth in M2, we should probably be closer to $1600 gold.
Summary and Action to Take
Even after the rise to $1300, gold has a long way to go. Markets have proven themselves very volatile in pricing gold, so whatever you invest, be prepared to stomach losses in the short term. I would slowly be building up a gold stash. For those who can really stand volatility, silver is an even better option.
In terms of equities, two of my favorite stocks to track the price of gold are Royal Gold (NASDAQ:RGLD) and the Junior Gold Miners ETF (NYSEARCA:GDXJ). Royal Gold pays a nice dividend and is far less volatile than junior gold miners, but the possible return with the juniors is massive. Invest accordingly.
Disclosure: I am/we are long RGLD, GDXJ.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.