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During the Second World War, a popular saying among the rich and powerful in England went … ‘When you hear the wails of the air raid sirens or the klaxons, buy gold.’

There was wisdom in this argument.

For around 3,000 years, mankind has taken shelter in gold – both as a store of value and as an investment.

In recent years, central banks around the world have been stocking up on gold in large quantities.

This trend has been driven by several factors, including concerns about currency stability, geopolitical risks, and inflation.

Let’s take a closer look at this by understanding why central banks are buying gold, the role of M2 money supply in this trend, and how Forex traders can potentially profit from this market environment.
 

Central Banks’ Love for Gold

Central bank’s demand for gold hit a record in 2022, with demand totaling 1,136 tonnes 2022.

This was not only the thirteenth consecutive year of net purchases but also the highest level of annual gold demand by central banks on record back to 1950.

This begs the question as to why central banks are loading up on gold of late and there are several reasons for that.

One reason is that gold is a hedge against currency instability. Many central banks hold large amounts of foreign currency reserves, which are vulnerable to fluctuations in exchange rates. By holding gold, central banks can diversify their reserves and reduce their exposure to currency risks.

Another reason is that gold is a safe-haven asset that can provide protection against geopolitical risks. With tensions rising in many parts of the world, central banks are looking for ways to protect their reserves from the potential fallout of a geopolitical crisis.

Finally, central banks are buying gold as a hedge against inflation. Gold has historically been an effective store of value and a hedge against inflation, making it an attractive investment for central banks that want to protect their reserves from the erosive effects of inflation. 
 

Role of M2 Money Supply

The M2 money supply is a measure of the amount of money in circulation in an economy i.e. cash, checking deposits, and other forms of liquid assets. 

When the M2 money supply increases, it may lead to inflation, which may further erode the value of the currency and other assets. As a result, central banks may turn to gold as a way to protect their reserves from the impact of inflation.

In addition, the M2 money supply can potentially influence the price of gold.

When the M2 money supply is high, it can lead to higher inflation expectations, which may cause investors to turn to gold as a safe-haven asset. This increased demand can drive up the price of gold.

Here’s how the M2 supply in the U.S. has been in the last few years:

(Click on image to enlarge)

As the central banks continued with their extra accommodative monetary policies with lower interest rates, the M2 supply has risen a tad sharply in the last few years.

Let’s study this a bit further…

When we divide the M2 money supply by the price of gold, we get the M2/Gold Ratio which basically tells us how overpriced or underpriced gold is compared to the M2 money supply. 

When the ratio is high, it indicates that the value of the U.S. dollar is low relative to the value of gold. This can be a sign of inflationary pressures and may prompt central banks to buy more gold as a way to protect their reserves.

Another thing to pay heed to is the central bank’s balance sheet in comparison to the gold prices.
 

Fed’s Balance Sheet & Gold Prices

The Federal Reserve’s balance sheet is a measure of the assets and liabilities held by the central bank.

When the Fed expands its balance sheet by purchasing assets, it can lead to an increase in the M2 money supply, which can in turn impact the price of gold.

Over the past few years, the Fed has expanded its balance sheet through a series of quantitative easing programs. This expansion has led to an increase in the M2 money supply and a potential rise in the price of gold.

Apart from this, the central bank also conducts repo and reverse repo operations each day as a means to help keep the federal funds rate in the target range set by the Federal Open Market Committee (FOMC).

One key factor is the reverse repo rate operations. The reverse repo rate is the rate at which the Fed borrows money from the banks for the short term. It is an important policy tool to maintain liquidity and check inflation in the economy. In short, the reverse repo rate helps the central bank get money from the banks when it needs it.

Here’s a look at what these reverse repo operations for the Federal Reserve Bank of New York look like over the years…
 

Reverse Repo Operations

Source: newyorkfed.org

We can see a massive spike in reverse repo operations in the last two years! 

In April 2021, the value of reverse repo operations (or reverse repurchase agreements) was just over $35 billion. And they’re currently at over $2 trillion!!! (What are your thoughts on this? Let us know in the comments!!)

Remember, with a reverse repo operation, the Fed sells the treasury bond for cash, taking money back out of the economy. And ultimately, banks are forced to repo the money they got from the Fed back to the Fed.

As for gold, the above ruthless repo operations and money printing by the Fed can weigh on the dollar and it can potentially mean good times for safe haven assets like gold.

However, do note that the relationship between the Fed’s balance sheet and the price of gold is complex and subject to a range of factors, including inflation expectations, geopolitical risks, and market sentiment. Moreover, gold prices are influenced by many other key monetary and economic factors.

Forex traders can potentially profit from central banks buying gold by taking advantage of the correlation between gold and the U.S. dollar.

When central banks buy sizable gold, it can lead to a potential decrease in the value of the U.S. dollar relative to other currencies. Traders can take advantage of this trend by tracking this trend and strategizing their trades accordingly.

If you’re a Forex trader looking to profit from the above trend, make sure you’re on top of all the market insights and strategies.

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