The Real Driver of Gold Prices

Gold is one of the most widely held assets, and investors often consider this precious metal as a reliable hedge against market downturns.

Proving its worth from this front, gold had a stellar run in 2020. The Nasdaq was the best performing market index in 2020, and gold was not far behind. More importantly, the maximum drawdown of gold was considerably lower than that of the Nasdaq or any other asset class for that matter, which highlights the diversification benefits of investing in gold.

Source: World Gold Council

It is common knowledge that interest rate decisions, economic growth, inflation and the strength of the U.S. dollar can have a major impact on gold prices. What is lesser known is that the real interest rate is also a driver of gold prices. A careful analysis reveals gold might lag the market considerably in the coming years, but there is reason to believe investors should still keep faith in gold for the long run.

Empirical evidence

• GLD 30-Year Financial Data
• The intrinsic value of GLD
• Peter Lynch Chart of GLD

The 30-year Inflation-Indexed Treasury bond yield provides a good proxy for real interest rates in the United States. The yield touched 0.78% in mid-March 2020 but plummeted to negative territory along with the emergency rate cut delivered by the Fed in response to the economic recession. Since then, the yield has not been able to gain positive momentum, which created a good platform for gold prices to reach new highs. A side-by-side comparison of this yield and gold prices will help investors understand the strong negative correlation between these two variables.

Source: Federal Reserve and Macro Trends

This quantifiable relationship between real rates and gold prices provides a good starting point for any analyst to determine the future outlook for this precious metal by plotting the movement of real interest rates.

The outlook is mixed

The next question, therefore, is how to identify the drivers of real rates. First, it's imperative to get an understanding of how real rates are calculated.

Source: Federal Reserve Bank of San Francisco

Inflation is likely to tick higher in the second half of this year along with the expected growth in the economy (indeed, this is what the Fed has stated it is aiming for), and the pent-up demand for leisure activities will further intensify this positive momentum.

Under normal circumstances, the Fed would have hiked nominal interest rates, creating a slow but steady upward movement in real interest rates. This time around, however, the Fed wants inflation to pick up strongly and keep the momentum, and interest rates are likely to be maintained at lower-than-optimal levels to support the revival of the American economy (in particular, companies with high debt). In such a scenario, real rates will continue to remain under pressure, helping gold prices regain some lost traction.

This, however, is not a sustainable strategy in the long run. Sooner or later, policy rates will need to be hiked. Changes to the nominal interest rate will not result in an equal change in the real rate, but historical has shown that real rates are bound to move higher when this happens.

Source: Federal Reserve

When the Fed decides it's time to put an end to its quantitative easing policy, which could be as soon as the end of this year going by the stellar economic growth projections for 2021, real rates will slowly but surely head higher. This suggests we are currently seeing the bottom of real rates. This does not come as good news for short-term gold investors, but long-term oriented investors need not panic.

There are many uncertainties

The above assumption is based on the optimistic assumption that the U.S. economy will perform as analysts expect in 2021. More often than not, predicting the macroeconomic outlook has proved to be a futile task because of the rapid changes that occur unannounced. Even though there are many promising signs about a strong economic recovery, things could go south if, for example, the vaccination program fails to make the desired impact. On the other hand, consumer confidence might not increase as expected if geopolitical tensions arise between the U.S. and other nations, especially China, which might provide an incentive for consumers to save rather than spend.

The global economy will continue to go through different stages of the business cycle, and it would be impossible to time the changes to perfection, meaning every investor should allocate at least a small portion of investable assets to gold because of its ability to act as a hedge against market corrections.

Could Bitcoing replace gold?

To the surprise of many value investors, some market participants consider Bitcoin to be a better alternative than gold to hedge market risk. Ray Dalio (Trades, Portfolio) recently opened up on this issue in a short essay he published on LinkedIn and commended what this digital currency has so far achieved. The guru wrote:

"Those who have built it and supported the dream of making this new king of money a reality have done a fabulous job of sustaining that dream and moving Bitcoin (by which I mean it and its analogous competitors) into being an alternative gold-like asset class. There aren't many alternative gold-like assets at this time of rising need for them (because of all the debt and money creations that are underway and will happen in the future)."

This statement came as encouraging news for Bitcoin bulls, but the guru went on to claim that governments around the world will never let a cryptocurrency do what gold has done in the past, meaning Bitcoin is far from being the best hedge against market downturns.

Takeaway

Even though many investors are aware that macroeconomic factors play a critical role in determining gold prices, not so many have a clear understanding that the real interest rate is the primary driver of this precious metal. The outlook for the short-term is positive, but gold prices are very likely to retreat or trade sideways in the next three to five years. Contrarian investors might want to allocate assets to riskier asset classes, but value investors with an extensive investment time horizon should continue to hold gold because of the diversification benefits associated with this commodity.

Disclosure: The author owns shares in SPDR Gold Trust ETF (GLD).

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