A fundamentalist Central Bankers gold pricing model – OR – Is gold really worth $2,380?
As gold prices jumped to over $1300 today lets imagine what a central bank should pay for gold if they were treating it like an investment.
A fundamentalist Central Banker would only be prepared to pay for gold what they believed they will receive from it in future. Gold’s lacks an available yield for an average investor which is why Warrant Buffet says he doesn’t invest in gold (“Gold does nothing but look at you”. But previous posts have discussed the idea that gold does have yield for central banks through the gold leasing market, a topic I wrote a paper on here with Prof. Brian Lucey. This post will uses lease rates and discount factors to estimate fundamental values for gold.
I will use 12 month lease rates as shorter lease rates frequently went negative over the past number of years and we will assume that central banks are long term investors in gold. Below are the annual dollar cashflows you could have earned by leasing gold. Following a period of unusually low leasing cashflows before the financial crisis there has been a recovery due, primarily to higher gold prices. On average you would have earned $4.72 from leasing one ounce of gold from 1989 to 2015. Pre-2000 the average was higher at $5.73 and post-2009 it averaged $5.95 per ounce.
A fundamentalist central bank would assess what they think gold is worth based on the annual cashflow they could receive divided by the relevant opportunity cost of capital. This blog estimated that gold’s Opportunity cost of Capital would be 0.25% if we assume it is a risk free investment, 1.25% if we assume that the central bank’s investment is as risky as an interbank loan (12 month LIBOR) and 0.98% if we treat gold’s alternatives through the Capital Asset Pricing Model. If we divide the above cash flows we get the below range of answers.
The table shows the various estimates based on the assumptions. If the central bank assumes that the average return is biased downwards by the slump in leasing cashflows in the mid 2000’s then they can take one of the higher estimates as their guess about future cashflows. The lower the risk the central bank perceives in leasing their gold the lower the discount factor they would choose.
This shows a very wide range of estimates from $377 to $2,380. The truth probably lies somewhere between these points as gold leasing cannot be as low risk as a three month loan to the US government. Assuming that cashflows stayed at current highs this implies that Central banks should be willing to pay a price of about $1,154.
The biggest problem with this analysis is that central banks do not buy gold so that they can lease it for yield. They only lease a tiny proportion of their combined gold holdings and anecdotally many central banks are not active in the lease rate market at all. Also central banks are not profit maximizing investors chasing yield as the above model assumes.
But since all attempts to value gold are at best guesses then this is as valid as any.