I’ve been writing gold miners this week.
You can read the articles here and here. I’ve been making the case that now could be a good time to invest in miners because they’re near the bottom of their “capital cycle”. The bottom of the capital cycles is normally a good time to invest in commodity companies.
I’ve stayed away from the demand for gold, and focused on what’s going on inside the miners. But since I’ve come this far, I might as well give my two cents on what I think drives the gold price. Obviously, that’s important to understand if you’re considering investing in miners.
It all boils down to one number.
The real interest rate is the number to watch
You’ll have read a few different arguments for gold over the years.
Some say that our monetary system is fatally flawed and is ultimately going to collapse. Some say that gold is a hedge against inflation. Some say it’s good protection against a panic in the banking system.
There’s a certain amount of merit to those arguments… but they’re messy. It’s hard to disentangle cause (is the bad thing going to happen?) from effect (if the bad thing happens, will gold go up?). In some cases, the cause part isn’t very likely. In other cases, it’s not clear that the cause would actually make gold go up.
Instead of all that I just focus on one simple number: the US real interest rate. I look at real interest rates – to the exclusion of everything else – because they seem to determine the gold price.
Look at the following chart. It shows the US 10 year inflation protected government bond yield (TIPS), vs the gold price. TIPS is a proxy for real interest rates. It’s a special type of government bond that pays a return over the inflation rate.
Why gold follows TIPS
As you can see, gold and TIPS move inversely. A 1% change in the TIPS yield has moved the gold price by (roughly) $400/oz since the data series starts in 2003.
This makes perfect sense. Gold is an old store of value, but it doesn’t pay any returns. So, when the returns on offer in the market dry up, gold gets more appealing.
To put it another way: the real interest rate, and the TIPS spread, is a sort of proxy for the amount of extra stuff you can buy in the future if you forego buying stuff now. When the market is booming and there’re loads of investment opportunities, that pushes interest rates up (more stuff in the future). When inflation is high, the price of future stuff goes up (less stuff in the future). The real interest rate puts those two numbers together.
The lower that real interest rate number is (ie, the less future stuff-buying you have to forego), the more you just want to put your money in gold, where at least it’ll be safe. Gold may not pay you any income. But it’s got a good long run record of holding its value.
The nightmare scenario for gold is high returns in the market and low inflation (like the 1990s). The dream scenario is low returns and high inflation (like the 1970s). The recent peak for gold came in 2011 – a time of lowish inflation but very low interest rates.
All in all, gold is a sort of a barometer of the health of our contracts and law and promises based economic system. If the system is humming it should be able to generate 2% real returns for investors every year. If the system is broken in some way (either too depressed to generate returns, or too inflationary), that’ll show up in real interest rates. And gold will go up.
So what does that mean for the gold miners? Well, I’m afraid I don’t have a clear answer on that. Inflation is low right now, and despite all the hot talk about money printing and QE, the big central banks are clearly terrified of it. So that’s bad for real interest rates, and gold, and gold miners. But on the other hand, long term interest rates are stuck in a rut. Good for real interest rates, gold, gold miners.
So there you have it: real interest rates are a useful way to think about gold prices. But not a crystal ball!