Authored by Kevin Muir via The Macro Tourist blog,
With the rising global political tensions, gold has gotten a bid over the past week. But is that what is driving the price?
Over the longer term, I would argue that real rates are the most determining factor affecting the price of gold. Too many investors believe inflation drives gold prices. They recount the great bull market of the ‘80’s and incorrectly assume inflation caused the monstrous rally. Well, inflation was important, but the ultimate determinant was the fact that inflation was considerably higher than interest rates.
The next great bull market (‘01 to ‘11) occurred during a period of relatively low inflation (especially when compared to the roaring inflation of the late 70’s.) Yet these two periods did have one thing in common. During the early 2000’s, interest rates were once again lower than inflation, pushing real rates to negative levels. At the peak of the gold bull run, the US 30 year treasury was yielding 100 basis points less than inflation!
Of course it is difficult to decide which interest rate term to use when discussing real rates. And there is even more debate about whether inflation is accurately measured (most would agree it has become progressively muted with increasing hedonistic adjustments). But the important point to realize is that precious metal rallies are born from periods when interest rates on fiat currencies are less than the rate at which the general level of prices rises.
Gold yields nothing and is no one’s liability. When governments are conducting prudent monetary policy, it makes little sense to own an asset that earns nothing. Yet when interest rates are set too low, and financial repression occurs, gold is the ultimate asset. That is why many market participants call gold the “anti-Central Bank asset”.
Let’s return to the latest day to day squiggles in the gold market and see if real rates are still driving prices.
Nowadays there is an active TIPS (Treasury Inflation Protected Securities) market that enables us to measure much more accurately the “real rate.” After all, by definition, the yield on this TIPS security will be rate of interest an investor will earn after inflation.
When we chart out the inverse of the 10 year TIPS’ yield alongside gold, the relationship becomes obvious.
However, over the past month, gold seems to have run ahead. Maybe this is due to the increased geopolitical tensions. But just to be sure, let’s check the US Dollar Index chart to see if maybe greenback weakness is driving the latest gold outperformance.
Even though there is a tendency amongst traders to assume gold is just an inverse US dollar play, this chart shows that the relationship is loose at best.
But maybe we are looking at the wrong currency. While I was stumbling around my chart book, I came upon a chart of gold versus the Japanese Yen.
Whereas the gold / US dollar index is tough to spot, the gold / Yen relationship is obvious. And most interestingly, since the beginning of 2016, it seems to have strengthened.
Just for kicks, I performed a regression analysis on the two assets. I divided it up into two periods. One from 2016 to present day (top panel), and the other, from 2011 to the end of 2015 (bottom panel).
The decrease in the standard deviation of the error from 1.044 to 0.703 in the latest period shows how much the relationship has tightened up.
I am not sure what this means exactly. If I didn’t know better, I would be tempted to guess that the Bank of Japan is pegging their currency to the price of gold.
But I want to stress that gold has not moved up solely because of Syria/Russia/North Korea/China/US tensions. Yeah maybe there is an extra $20 to $40 dollars in it, but the real trend is being driven by other factors.