Gold continues to divide opinions.
The yellow metal’s supporters insist that every investor should have some, that it’s still the classic go-to safe haven in times of potential financial panic and that the gold price is poised to surge – probably in the very near future.
In contrast, gold’s detractors claim that it’s now an anachronism. They maintain that, apart from its uses in the likes of jewellery, it doesn’t serve any useful purpose or generate any income. Cryptocurrencies, they say, are better safe havens.
Not sure about that, but this article is about gold itself, not crypto. Today I review the metal’s recent history and examine what could trigger the next price rise and how large this move might be.
Some people will try to tell you that the technical background to bullion’s price action is very complex. Yet the gold story is pretty simple. This chart sums it up…
Click to enlarge
Source: St Louis Fed, Daily Reckoning
It’s from America’s Federal Reserve Bank of St Louis, which calls itself Fred for short. (Fred, by the way, provides a vast amount of economic data and build-it-yourself charts and is well worth looking up).
Back to the graphic: the red line shows the gold price in American dollars over the last decade. As you can see, during the last decade it’s been inversely correlated – indeed, quite remarkably so, as I explain lower down – with the blue line.
That’s the yield on US 10-year Treasury Inflation-Indexed Securities (TIPS).
Technical time-out: TIPS are the broad equivalent of Britain’s index-linked gilts. The yield on a TIPS bond is equal to the annual income return of an equivalent duration US Treasury security – minus America’s inflation rate – and is otherwise known as the long-term real interest rate.
Partly right popular views
It’s a popular belief that increases in interest rates by themselves are bad for bullion. Inflation, meanwhile is supposed to improve its value.
But both views are only partially correct.
Sure, higher interest rates do make it more expensive to hold non-interest bearing assets such as gold, making the metal less attractive to investors.
Economists call this a ‘greater opportunity cost’. And inflation increases mean that money is worth less, so gold should become more valuable when measured in cash terms.
To repeat, though: the real driver of the gold price, as the above chart shows, is the US real interest rate – which is currently around 0.5%. And the real interest rate has two variables: nominal (i.e. actual) interest rates and inflation.
Gold only comes under pressure when nominal rates rise faster than increases in the consumer price index.
Further, before the great financial crisis that began a decade ago, the real interest rate was also viewed as being roughly equivalent to the real economic growth rate.
Now the US economy has been expanding someway faster than 0.5% in recent years. For example, 2017 Q3 annualised real growth was 3%.
Here’s where the Fed’s constant market meddling has had such an impact.
Quantitative easing policies, in other words America’s central bank buying bonds, have pushed up prices (and therefore driven down yields) on US Treasuries. You can see the effects on the chart, in particular between mid-2011 and end-2013.
That’s when TIPS yields dipped into clearly negative territory despite average US economic growth rates of around 2%. It was a great time to be a gold investor.
Since the real interest rate turned positive again in mid-2013, gold hasn’t had it as good.
While the real rate has moved sideways since then, bullion has done likewise.
Looking forward, then, all that gold investors need to do is guesstimate where the TIPS yield will go in the future. History shows that the gold price measured in US dollars is highly likely to head in precisely the opposite direction.
That’s easy to say, though of course, it’s rather more difficult to predict.
None of us has a crystal ball.
But we can make some reasonable assumptions.
Here’s a chart of US inflation (red line) and nominal 10-year Treasury yields over the last 30 years, again for which many thanks to Fred.
Click to enlarge
Source: St Louis Fed, Daily Reckoning
As you can see, while both have fallen a long way over that period, bond yields have fallen much more than inflation. So if both were to turn up, we might expect real rates to rise once more into line with current levels of economic expansion.
But how likely is this? While US core consumer prices could pick up in the near term, over the long run I reckon there’s more chance of the opposite happening.
The post-financial crisis economic recovery is now very long in the tooth. At this stage of the business cycle, recession appears more likely than inflation.
Both stock prices and lower-grade corporate credit – junk bonds, in other words – look vulnerable to significant falls.
We know what central banks are likely to do in those circumstances: Negative interest rates could soon be back on the agenda.
So the scene is being nicely set for the next bull market in bullion. Again, the chart shows us that 0.8% negative real yields powered gold to $1,800 per ounce.
In the next crisis, central banks could engineer even larger negative numbers. That could lead to a gold price well in excess of $2,000/ounce.
I believe that the only key question left is ‘when’, not ‘if’, negative real rates return to boost gold. That’s harder to answer. But if you don’t already hold gold, the only way to ensure that you won’t be caught out – when it does take off – is to buy some.
Fortunately, my colleague and gold expert Simon Popple will be revealing a major gold opportunity that he’s kept close to chest over the last few weeks…
Those details will be hitting your inbox very soon.