How Does Gold Perform When Inflation Is High? – (Backtest, Performance, Strategy, Results Analysis)

Throughout history, gold has consistently held its position as the preferred global currency. Now, investors primarily acquire gold as a safeguard against economic instability and, of course, inflation. How does gold perform when inflation is high?

Gold has famously been considered a hedge against inflation because of its low correlation with other investment assets. However, how profitable is gold during high inflationary periods?

In this article, we will look at what drives the price of gold, develop a trading strategy, and backtest the performance of gold in inflationary periods.

Related reading: – Searching for a list of free trading systems? (We have hundreds)

What drives the price of gold?

Gold prices are driven by a combination of supply and demand, the value of the US Dollar, investors’ behavior, and risk appetite. Besides demand from investors, gold is primarily demanded by central banks to build up their reserves. In certain parts of the world gold is in high demand for jewelry. In the first half of 2022, jewelry accounted for 44% of gold demand. Technology and manufacturing uses only represented 7.5% of the gold demand.

China, South Africa, the United States, Australia, Russia, and Peru are among the prominent participants in global gold mining. In 2020 and 2021, gold mine production averaged approximately 3,000 metric tons per year, experiencing a decline from its peak of around 3,300 metric tons per year in 2018 and 2019.

As we mentioned earlier, the value of the US dollar also plays an important role in the price of gold. All else being equal, a stronger U.S. dollar generally exerts downward pressure on the price of gold, ensuring greater stability and control.

Conversely, a weaker U.S. dollar tends to increase the demand for gold, leading to higher prices (as more gold can be bought with a weaker dollar).

Consequently, gold is frequently considered a safeguard against inflation. Inflation occurs when prices rise, and correspondingly, prices rise when the value of the dollar declines. As inflation intensifies, the price of gold also tends to rise. 

We decided to put this theory to the test and develop and backtest a trading strategy to see how gold performs in high inflationary environments.

How does gold perform when inflation is high? – trading rules

The trading rules of the strategy we are going to backtest are pretty simple:

• We buy and hold gold when CPI is at or over 3% YoY
• We sell and maintain cash when CPI is under 3% YoY

How does gold perform when inflation is high? – backtest

We backtest the strategy using the monthly closing price of gold from the Commodities Markets Database on the World Bank website. For the sake of showing other results, we also backtest the performance of the strategy when CPI is over 2.5% and when it’s over 4%.

Here is the equity curve:

Here are some metrics and statistics about the performance of the strategy when CPI is over 3%:

• CAGR is 4.15% (buy and hold 6.57%)
• Time spent in the market is 50.2%
• Risk-adjusted return is 8.26% (CAGR divided by time spent in the market)
• Maximum drawdown is -62.53% (-62.08%)

As you can see, although the strategy of holding gold when inflation is higher than 3% performs better than buy and hold on a risk-adjusted basis, the maximum drawdown is practically the same.

How does it compare to the SPX (S&P 500)? Here it is:

Effectively, having held gold when inflation was higher than 3% compounded money at a higher return than if you would have held the S&P 500 (during the same period).

How does gold perform when inflation is high? – conclusion

To sum up, today, we showed you how gold performs during periods of high inflation. While its returns may not be substantial, they have been good on a risk-adjusted basis and surpassed those of the S&P 500. This trend has held true in the present economic cycle, providing evidence that it is not merely coincidental, as some skeptics suggest.

FAQ:

Why is gold considered a preferred global currency throughout history?

Gold has historically been considered a preferred global currency due to its intrinsic value, durability, and limited supply. Investors often acquire gold as a safeguard against economic instability and inflation. Gold is considered a hedge against inflation because of its low correlation with other assets. During high inflation, the value of the U.S. dollar tends to decline, and gold, being inversely related, often sees an increase in demand and price.

What are the driving factors behind the price of gold?

The price of gold is influenced by a combination of factors, including supply and demand dynamics, the value of the U.S. Dollar, investor behavior, risk appetite, and central bank activities. Global gold mine production and jewelry demand also play crucial roles.

How does the value of the U.S. Dollar impact the price of gold?

The value of the U.S. Dollar plays a significant role in the price of gold. A stronger U.S. Dollar tends to exert downward pressure on gold prices, while a weaker U.S. Dollar often leads to increased demand for gold, causing prices to rise.