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Gold Return vs. Change in M2

| | Posted in: Economic Indicators, Gold

A subscriber requested testing of the relationship between U.S. M2 Money Stock and gold, offered in one form via "Why Gold May Be Looking Cheap": "[O]ne measure I’ve found useful is the ratio of the price of gold to the U.S. money supply, measured by M2, which includes cash as well as things like money market funds, savings deposits and the like. The logic is that over the long term the price of gold should move with the change in the supply of money... That equilibrium level is also relevant for future price action. When the ratio is low, defined as 25% below equilibrium, the medium 12-month return has been over 12%. Conversely, when the ratio is high, defined as 25% above equilibrium, the 12-month median return has been -6%. ...This measure can be refined further. [G]old tends to trade at a higher ratio to M2 when inflation is elevated." Because it defines specific valuation thresholds, this approach is susceptible to data snooping bias in threshold selection. We consider an alternative setup that relates monthly change in M2 to monthly gold return. We also consider the effect of inflation on this relationship. Using monthly seasonally adjusted M2 and end-of-month London gold price fix during January 1976 (to ensure a free U.S. gold market) through June 2018 (510 months), we find that:

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