The Gold-Rates Relationship Is One To Watch

At a Glance

  • Since the financial crisis, gold price movement has corresponded to changes in real rates
  • Gold’s strong performance since mid-2018 occurred as central banks took a more accommodative stance 

At last, gold bugs have something to celebrate. In February, the yellow metal broke through $1,650, a level not seen since 2013, when gold entered a prolonged bear market. What is driving the gold price higher and how may market fundamentals influence its price in the future?

A look at the evolution of gold prices since the great financial crisis shows that movements in gold prices often corresponded to changes in real rates. Gold increases when real yields drop, and vice-versa. Real rates are usually defined as 10-year treasury yields (essentially, a yardstick for the return of risk-free securities) minus inflation.

Source: Bloomberg, GC1 Comdty and RR10CUS Index

Rates-Gold Inverse Relationship

Real rates capture the inflation-adjusted opportunity cost of holding gold in a portfolio. Gold does not yield any cash flows, and low rates mean that a gold holder does not lose out on much interest income. When rates are high, an investor will reduce gold holdings and reallocate funds to higher yielding assets, leading to lower prices for the precious metal.

Looking back over the past 30 years, the negative relationship between gold and real rates has been strong. The highest gold prices were recorded in an environment of low or negative real rates and high rates tallied with low gold prices.

Source: Bloomberg, GC1 Comdty and RR10CUS Index

Central Banks Are Accommodating

The severe gold price correction of 2013 coincided with a strong increase in real yields. During that period, the Fed announced that it would start tapering its policy of quantitative easing. Traders pushed treasury yields upwards in the expectation of higher policy rates. In the absence of an offsetting increase in inflation, real yields also went sharply higher, knocking gold down to levels of around $1,200.

The strong performance of gold since mid-2018 occurred concurrently with important developments in the interest rates and inflation complex. Central banks across the world have taken an accommodative stance in the light of macroeconomic uncertainty.

The Fed conducted “mid-cycle” rate cuts. The ECB and the Bank of Japan resumed or increased quantitative easing operations to stimulate demand in their economies. Current treasury yields reflect market expectations of low rates for the near-to mid-term future.

What About Inflation?

After many false dawns, there are signs that inflation could make a return. Eurozone inflation reached a six-month high of +1.3% annually in December 2019, and the U.S. CPI (Consumer Price Index) accelerated to +2.3% annually that same month.  Commentary from central bankers such as Fed governor Lael Brainard indicate that the Fed may let inflation overshoot its own 2% target level to expedite a return to a more “normal” monetary police regime.

Many elements that impact the rates complex also directly impact gold. The metal has been, throughout ancient and modern history, the safe-haven asset of choice. Inflation is greatly influenced by energy prices. A shock to global energy markets, like the attack on Saudi oil facilities witnessed in September 2019, could trigger both higher oil prices – increasing inflation, driving real yields lower – and bolster safe-haven demand for gold.

Similarly, central bank dovishness may be called upon to stimulate growth if global trade conflicts or the after-effects of the coronavirus outbreak impact the global economy. In such a scenario, demand for a flight-to-quality asset such as gold should increase. Of course, the opposite scenario is also possible: After signing their phase one deal in January, the U.S. and China may engage in further trade détente. As long as flashpoints in the Middle-East do not lead to all-out conflict, oil markets should be well supplied, limiting the danger of runaway inflation.

In either scenario, the gold-real rates historic relationship appears to be on firm footing.

Gregor Spilker is Director of Energy Research at CME Group. He is based in London.

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