Real Interest Rates And The Impact Upon Gold Prices
We have a quick question here from Ryan, asking what is golds relationship with real interest rates, and how can we track real interest rates?
Apart from golds obvious correlation in the short term with something like the US dollar, as well as risk sentiment, one of the key drivers for gold is US interest rates, and especially real interest rates. Now real interest rate simply means that it is the inflation adjusted interest rate.
For example, if interest rates are sitting at 2%, or let’s say your US government bond yield, for example, as well is sitting at 2%, but inflation is currently at 3%, it means that you have a negative real yield, or negative interest rates, depending on whether you’re referring to your yield or your interest rate itself. Now, that is significant because unlike bonds, gold doesn’t pay any dividends or interest.
So investors will basically lose out on opportunity cost if they choose to hold onto something like gold, which won’t pay them any dividends, or any interest, like a stock or an equity et cetera, when real interest rates are high, and they can basically get a lot more for their money, a lot higher return for their money in other asset classes.
But when real interest rates go down, gold becomes more attractive, as they become very cheap to hold in a portfolio as the carry cost for gold become very, very low.
Now this is made even worse when the actual interest rate, real interest rates in the country, go into negative territory, for example if inflation is sitting at 3% and your interest rate is sitting at 2%, it means that it’ll actually cost you to hold onto you money, which means holding something like gold will actually be a lot safer place to keep your money as a store of wealth.
Now, when interest rates go up, there is obviously a huge outflow of bonds, as there are much higher rates of return in other asset classes, like stocks and equities, et cetera, and as bond prices go down, due to that lack of demand, the yield will obviously rise, because the government needs to pay more yield to make people interested in actually buying the bond.
When this happens, the cost of holding something like gold becomes very, very high, compared to your rate of return that you get for it, compared to something like a stock. In the opposite end, when interest rates go down, like we’ve seen over the last let’s say two years, there are usually lots of inflows into bonds as the risk of return in other asset classes becomes much lower.
That increase in demand for bonds obviously pushes the prices for bonds up, which in turn pushes the bond yields itself lower, and as real rates start to decrease, so the actual interest rate starts to get lower, gold becomes much more attractive alongside something like bonds.
A good proxy that you can use for real yields is using TIPS. You can see TIPS is basically this orange line. In red we have gold prices, in orange we have TIPS. TIPS is just an ETF that basically tracks inflation protected US securities like bonds. Thus TIPS and gold has a very high positive correlation. So whenever we see inflation protected bonds basically go down, we see gold prices follow.
Whenever we see inflation protected bond prices go up, we normally see gold prices follow. Apart from TIPS, apart from the positive correlation, you can also just use the normal US government 10 year bond yield as a negative correlation. Also a very strong negative correlation. If you don’t have access to TIPS you can obviously use that. It won’t be an inflation protected measure like TIPS, but still fine.
You don’t always need to use real yields. It’s just a much stronger correlation with real yields, but using the US 10 year government bond yield as in inverse correlation measure of gold is also widely used in the trading sphere. So also something that you can use.
For now you can use something like TIPS, which has a more positive correlation. It is also inflation protected, which means that it will give you a more real yield correlation with regards to gold, but you can also, as we said, use something like the US government 10 year yield, which will also fine as a reverse correlation to gold prices.
I hope that helps. If there’s anything that’s unclear, please let us know and we’ll make sure to get back to you.