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Dilantha De Silva
Dilantha De Silva
Articles (182)  | Author's Website |

The Real Driver of Gold Prices

The short-term outlook for gold is promising, but it could soon change

February 01, 2021 | About:

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

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.


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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About the author:

Dilantha De Silva
I am an investment professional with 5-years of experience in financial markets. I specialize in U.S. equities and incorporate a top-down approach to identify developing macro-level trends and the companies that would benefit from such trends. I am a strong believer that the best investment opportunities could be found in under-covered equities.

I currently work with leading financial publications including Refinitiv, Seeking Alpha, ValueWalk, GuruFocus, and TradeGrill to produce investment-related content.

I\\\'m a CFA level 3 candidate and an Associate Member of the Chartered Institute for Securities and Investment (CISI, UK). I am a registered candidate for the Chartered Wealth Manager program as well. During my free time, I enjoy reading.

Visit Dilantha De Silva's Website

Rating: 2.0/5 (1 vote)



Praveen Chawla
Praveen Chawla premium member - 2 months ago

I have some issues with this article which perhaps you can address.

First, you state that real interest rates are the driver of gold prices but have not presented any clear evidence to back up the premise.

Second, if inflation rises then common sense will dictate that gold prices would increase not decrease. How do you distinguish this effect from interest rates?

Third, the effect of the US dollar. Currently, USD is going down - as it goes down gold prices in USD will increase. Do you agree?

Fourth, Gold prices are affected by sentiment and sentiment is difficult to predict and it can last for years. How do you address that?

Fifth, economic conditions in Gold consuming countries like India etc.

There are so many factors affecting gold prices that it impossible to predict the final results.

Dilantha De Silva
Dilantha De Silva - 2 months ago    Report SPAM

Hi Praveen, I think you are totally missing the point here. "Clear evidence" is presented under empirical evidence. That's one thing. Second, all this idea of inflation and currencies and many other factors affecting gold prices is simply not true. Yes, if you Google it, the search results will tell you that all these factors matter. But in reality, gold has failed to react to any of those macroeconomic variables for more than a few decades. Remember the U.S.-China trade war and the significant bump in inflation in 2017-2018? Gold literally went nowhere! Gold declined from 1,290 per ounce to 1,260 whereas the US reported the highest inflation figures we had seen in over a decade. And in 2019, inflation declined but gold shot higher. How do you explain that? The answer is simple, The relationship between gold and inflation comes from the real interest rate. As a reminder, inflation is part of the calculation that we use to derive the real interest rate from the nominal rate.

f you continue to search on this subject, you will see that there is documented evidence (plus hundreds of research reports prepared by some renowned economists) to suggest that real rates are the key driver. As long as no changes to real rates occur, the movement in gold has been negligible more often than not. And yes, all the things you mentioned about the dollar definitely do matter. But once again, those are indirectly related to the real interest rate itself. If you have access to a data terminal, may I suggest you pull out the correlation charts between gold and the dollar, gold and nominal interest rates, gold and economic growth, and then compare it with the chart that I have provided in the "empirical evidence" section, and you will realize that gold exhibits the strongest correlation (negative) with real interest rates. And once again, inflation definitely does have a say in where gold prices would be but not in the way many investors think it does.

Praveen Chawla
Praveen Chawla premium member - 2 months ago

Thanks for the reply, Dilantha. The point is that the price of gold is likely dependent on multiple factors not just real interest rates. It is just not possible for someone to predict as you don't know which factors are predominant at any one time. BTW - real interest rates are by definition dependent on inflation or inflation expectations.

Dilantha De Silva
Dilantha De Silva - 1 month ago    Report SPAM

Yields are up. Inflation is up since I wrote the article. But gold is down. And that's because of real rates, and that is the relationship I plotted above. So gold has so far been a poor hedge against inflation. Common sense, it seems, does not dictate terms over gold. Yes, one might not be able to predict future prices of commodities or stocks but the ones who understand the real drivers behind a specific stock, bond, or commodity can and will do a better job. Thanks for your time!

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