From March 8 through April 24, gold rallied over 9%, outpacing the S&P 500 which was up just over 3% in the same period. The rally seemed to correspond with headlines of banking stress that could have the potential to alter the Fed's hiking path. For almost a year the U.S. treasury yield curve has been inverted leading many analysts to believe that the U.S. economy is headed toward a recession.

These and other factors have drawn increased attention to the gold market, where options on gold futures have reached record trading volume in 2023. Gold is believed to perform well in times of economic stress. But does it? Let’s look at history to tell us how gold performs under three scenarios – inflation, recession, and stagflation.

It would be nice if the answer to that question was a simple yes or no, but, unfortunately, it’s more complicated. The last major bout of inflation in the U.S. was the period between 1973 and 1979. During this time inflation averaged approximately 8.8% per year and gold gained an astonishing 35% annual return.

This would seem reasonable as inflation is associated with a weaker dollar and, in this environment, market participants are usually drawn to commodities to preserve purchasing power. But if we look a little deeper we see another element. Elevated oil prices were the primary driver of the 70’s inflation/stagflation. This is significant because it alters the way the Federal Reserve and the government feels it can fight inflation. Aggressive rate hikes are an effective tool if the cause is simply excessive demand in the system, but when the cause of inflation is an elevated input price like oil, the Fed can't fix it as easily with rate hikes alone.

Perhaps the gold market in the 70s was signaling a lack of confidence in the overall economic outlook and the Fed's ability to achieve success in its task.  It wasn't until the 1980s that Federal Reserve chairman Paul Volker decided that rates needed to be massively hiked to end inflation, even if it added to the economic stress. The current inflation is dissimilar in a couple of ways.

The 2021 inflation was caused by government spending, supply chain disruption, and rates held too low for too long. The first sign of inflation was seen in March of 2021 when the Consumer Price Index (CPI) ticked up significantly, printing a year-over-year increase of 2.62%. At the time, gold was trading around $1,700 per ounce. Over the subsequent months, both gold and inflation began heading higher with the CPI topping at 9.06% in July of 2022 and gold hitting its cycle high near $2,050 in March of 2022.

In the seven months following gold’s high, it lost 20% of its value, bottoming in October of 2022 at $1,625.  But what happened in March of 2022 that turned gold south? Perhaps it wasn’t a coincidence that March also marked the beginning of one of the Federal Reserve's most aggressive and most telegraphed hiking cycles in history. Predictably, the dollar rallied, and gold tumbled. It wasn’t until October that the market began to envision an end to higher rates. At this point, gold seemed to change its focus from the current high-interest rates to the market's prediction of coming rate cuts to combat a potential recession. 

On balance, gold seems to benefit from inflation but less so if the expectations are for the Fed to act decisively against it.  Simply put, gold likes inflation but doesn’t like the higher rates or the strengthening U.S. dollar that the Fed may engineer to combat it.