During the period of aggressive interest rate hikes by the Federal Reserve, the performance of gold has been quite intriguing. Despite the continuous rise in interest rates, the price of gold has not declined but instead maintained considerable resilience, contradicting its traditional valuation model based on the inverse relationship with US 10-year real interest rates and the US dollar.
This unexpected trend can be attributed to an unusual force - central banks. With investment and jewelry demand relatively stable, central bank purchases have reached unprecedented levels.
Given that real interest rates are still high and the safe-haven impulse triggered by the March banking crisis has been exhausted, it is crucial for the gold market to determine whether central bank gold buying will continue to provide the same support for future gold prices.
Last week, analysts from UBS led by Elena Amoruso published a research report analyzing the appropriate weight of gold in major central bank reserve portfolios. They found that the optimal allocation of gold ranges from 0.5% to 11.5%, and increasing the gold holdings is only reasonable when the target investment horizon exceeds 6 years.
Furthermore, UBS believes that despite the current trend of deglobalization, central banks may not further increase their gold purchases, which could limit the future performance of gold. However, traditional support may return, as the optimistic prospect of the Federal Reserve ending its interest rate hike cycle could lead to a weaker US dollar and a decrease in US real interest rates, which may alleviate the awkward situation faced by gold.
<h2>Risk/Return Trade-off: Optimal Allocation of Gold</h2>
By considering the risk/return trade-off, UBS predicts the official gold demand by examining the proportion of gold that central banks can allocate from a portfolio construction perspective.
UBS analyzed the response of typical central bank portfolios to precious metals, focusing on four different durations (6 months to over 6 years) of government bond portfolios and a conservative multi-asset portfolio consisting of 80% government bonds and 20% developed market stocks.
For the multi-asset portfolio, UBS selected the MSCI World Index, which designates approximately 60% to US stocks and the rest to other developed market stocks.
These portfolios mimic the composition of existing central bank reserve portfolios with different durations and levels of equity risk exposure.
UBS evaluated the impact of increasing gold allocation on its five model portfolios and found that the higher the risk of the portfolio, the greater the returns obtained from gold diversification.
<img src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/6ae98b45-361a-433d-bc57-96dae690793b.png?x-oss-process=image/auto-orient,1/interlace,1/resize,w_1440,h_1440/quality,q_95/format,jpg" alt="Gold Allocation Impact" original-src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/6ae98b45-361a-433d-bc57-96dae690793b.png"/>
Specifically, cash equivalents and fixed-income investment portfolios with very short durations (6 months and 1.5 years) hardly benefit from increasing gold allocations, as the risk-adjusted return of gold allocations plummeted to 0.5%.
However, for portfolios with longer durations, gold plays a significant role in hedging yield changes.
When the risk-adjusted return of a 3-year investment portfolio reaches its peak, the gold weight is 3.5%. When the portfolio duration exceeds 6 years or includes stocks, the optimal gold allocation is around 10%, and the highest risk-adjusted return occurs when the gold weight is 11.5% and 8.5% respectively.
UBS Bank stated that as long as gold allocations are increased in the portfolio, even in negligible amounts, the portfolio's return volatility will quickly rise, indicating a nearly linear relationship between gold allocation increments and volatility.
Technically, all portfolios can achieve the lowest return volatility when the gold allocation is 0%. However, small gold allocations (up to 5% for most portfolios and up to 10% for long-term fixed-income and multi-asset portfolios) do not seem to pose a significant threat.
Moreover, beyond these thresholds, the return curve becomes steep, indicating that a certain amount of gold allocation can achieve the optimal risk-adjusted return without excessively disturbing the portfolio's volatility.
However, the risk profile of long-term and multi-asset portfolios does not significantly decrease until the gold allocation exceeds 10-15%.
In summary, UBS Bank's analysis suggests that the optimal gold allocation for central bank standard reserve portfolios is often between 0.5% and 11.5%, depending on the portfolio's duration risk exposure.
<img src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/f862f692-fe76-4a87-affa-dd232f59d381.png?x-oss-process=image/auto-orient,1/interlace,1/resize,w_1440,h_1440/quality,q_95/format,jpg" alt="Image" original-src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/f862f692-fe76-4a87-affa-dd232f59d381.png"/>
<h2>Central Bank Gold Fever Unsustainable, Traditional Factors Return</h2>
According to UBS Bank's observations, developed economies seem to be heavily over-allocated to gold. Nevertheless, it is difficult for central banks' enthusiasm for gold to reverse after the global financial crisis. UBS Bank wrote in its report:
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For many of these countries, gold reserves are a historical legacy, and selling gold may conflict with public sentiment and national pride. Obviously, portfolio diversification and returns are not their concerns.
This can be clearly seen from the recent trend of gold sales by the European Central Bank. Emerging market central banks face more delicate decisions, and the pressure to globalize may prompt them to increase gold allocations. However, the balance between risk/return and liquidity demands may hinder this defensive move.
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UBS Bank stated that duration is crucial in determining gold allocations, and it is only reasonable to hold more than 3.5% of gold when the portfolio duration exceeds 3 years. Considering the shortened duration of reserve investment portfolios after the COVID-19 pandemic (currently a median of only 20 months), increasing the gold allocation to 7.8% is not reasonable from a pure risk-return perspective.
However, in a geopolitical environment that encourages diversification and moving away from assets denominated in US dollars or euros, gold, especially gold stored domestically, provides unparalleled security.
UBS points out that this may still conflict with their maintenance of liquidity in US dollars or euros, as well as the need to intervene in international balance of payments imbalances and their currency. In this case, it is best to store their gold in overseas institutions, which can be used as collateral for foreign exchange loans.
Of course, predicting the future path becomes more challenging when economic and geopolitical factors intertwine.
UBS believes that the central bank's gold purchases in 2023 are unlikely to reach the level of 2022. However, if the Federal Reserve ends its tightening cycle, the US dollar weakens, and US bonds strengthen, the traditional macro factors that support gold will return.

According to UBS observations, developed economies are significantly over-allocated in gold. Considering geopolitical uncertainties and other factors, central banks may continue to purchase gold this year, but it is unlikely to reach the level of last year.

Stop the "grand narrative," UBS: The story of central banks buying gold is over.