The buzz right now among most investors and virtually every economic commentator is on interest rates. It seems that at this point it's not a matter of if – but when – the Fed will begin raising rates with the majority sensing it may happen sometime between September, 2015 and Q1 2016. The last time the Fed raised rates was nearly 10 years ago in June of 2006. So needless to say, it's been a while since we've seen this shift in policy, and at this point there are a lot of guesses on how the economy and various markets will react.
Focusing in on the gold market specifically though, there are some very real risks that gold owners need to be aware of. Simply put, there are a number of indicators for gold, but one of the most compelling is the very strong negative relationship between the price of gold and real interest rates. It is widely recognized that rising real interest rates create a poor environment for gold, whereas falling real interest rates tend to push the price of gold up… let's look at why that is.
Gold is an expensive asset to hold. It offers no dividend and does not produce any interest. As such, in a higher real rate environment there is a high opportunity cost to holding the metal versus interest bearing assets such as CDs, bonds, etc. Conversely, when real interest rates are low (or even negative) investors see very limited returns (or real losses) on interest bearing assets giving a higher incentive to hold gold.
This impact is exacerbated as supply-demand shifts cause billions of dollars of both individual and institutional money to move in and out of metals as real rates change. Think about this logically. How likely are you to own a CD (or other interest bearing investment) when real interest rates are for example -2%? What about 1% or 6%? Obviously, you are more likely to own that CD performing at 6% and you would look to protect your capital another way if that CD was offering a real return of -2%.
Most investors view gold as a store of value, not too dissimilar from the idea of holding treasury bonds, CDs, etc as low-risk assets. Thus when real rates are rising we see money flow from gold into interest-bearing assets. When real rates are falling we see money flow from interest-bearing assets into gold.
This is a very strong indicator as to the direction in the price of gold. Understanding where real rates are going can aid you in buying gold at the right time – or protecting yourself by selling before a sharp decline in prices.
Source: Thomson Reuters Datastream, World Gold Council
Oftentimes people will say “But wait, gold was spiking in the late 1970s when interest rates were high and gold was falling in the 1980s when interest rates were low!” This is why we need to make the distinction between real and nominal interest rates. The nominal interest rate is the percentage of increase in money the borrower pays the lender. Suppose the bank lends you $100 at a 10% interest rate. When you pay back the $100 you're paying an additional $10 in interest. Simple, right? But this does not take into account the impact inflation has on the bank's return.
The real interest rate is adjusted for inflation. It measures the percentage increase in purchasing power the lender receives when the borrower repays the loan with interest after accounting for inflation. So continuing on with our example, let's suppose inflation is running at 7%, which essentially is a 7% loss in purchasing power. The bank is gaining a 10% increase in purchasing power from the interest it's being paid on the loan, but it is losing 7% purchasing power due to the cost of inflation. Therefore, creating the real interest rate, the bank is seeing a 3% (or $3) gain in real purchasing power on this $100 loan.
REAL INTEREST RATE = NOMINAL RATE – INFLATION
So yes, in the late 1970s nominal interest rates were high… but inflation was almost as high, and at times even higher! So if you have a nominal interest rate of 13% and inflation is running 14%, you have a negative real rate of 1%. With low (or negative) real rates gold tends to perform better, thus in the late 1970s we saw gold spike heavily.
During the 1980s nominal interest rates were falling, but the rate of inflation was falling even faster. This meant that even though nominal rates were coming down, real interest rates were actually rising. What happened to gold in the 1980s? Well, gold was $850/oz in January, 1980, and it dropped to $300/oz by 1985.
Indeed, one can make the argument that it was the low real interest rates of the mid-late 2000s that led to the price increase of gold, especially during 2009-2011. Economists like Paul Krugman have reiterated numerous times that gold was responding to changes in real interest rates – and not inflation alone.
In fact, gold prices are down a lot. But it's also important to understand why they were high in the first place. Gold is not, in fact, a hedge against inflation. It's something people buy when real returns on alternative assets are low. The figure shows the price of gold versus the interest rate on inflation-protected bonds inverted, so that a falling real rate of interest is a rise on the chart. Gold went up as real interest rates turned negative, thanks to a depressed economy — an economy, by the way, that was deflation, rather than inflation-prone.
And as recovery has gathered strength, real rates have gone up and gold has gone down.”
http://krugman.blogs.nytimes.com/2014/12/24/recession-recovery-and-gold/
So where do we go from here? The last few years have seen gold trend down as nominal rates have stayed flat while inflation has fallen – meaning real rates have risen. The Fed has been telling us for over a year now that they are going to be raising interest rates soon. Assuming rates do increase and inflation stays steady, or raises at a level slower than the increase in nominal rates, real interest rates will continue to rise. This would suggest a continued decline in the price of gold.
I'm not saying owning gold right now is good or bad. Everyone has their own reasons for owning the metals, and what makes sense for me may not make sense for you. And there are certainly other contributing factors that influence the price; it is a volatile commodity after all. But for me, I am hesitant to invest in gold as a performing asset given the current economic environment and outlook on interest rates.
