by Stefan Wieler, GoldMoney:
The correlation between gold prices and US nominal interest rates recently dropped to near record lows, which prompted some financial analysts and media sources to predict that further Fed interest hikes will inevitably lead to lower gold prices.
However, proper analysis shows that gold prices move with real-interest rates, not nominal rates. And while nominal interest rates are likely to rise further, real-interest rates are not, because inflation expectations are moving higher as well. In fact, we believe that even if the economy allows the Fed to raise rates several percent higher, real-rates have likely peaked and thus gold prices troughed. Being already in the second longest economic expansion in US history, odds are that the economy will begin to slow long before the FED has raised rates to its 3% forecast, which means that the ensuing monetary easing will push real-interest rates into negative territory and gold prices higher again.
For the past few months, gold prices have largely followed the moves in nominal interest rates. Depending on how one analyses the correlation between gold prices and nominal interest rates (10 year US government bond yields), the correlation coefficient is anywhere near record lows and the lowest levels since data is available (1962), meaning that gold prices have recently moved almost perfectly diametrically opposed to nominal interest rates. This has led some commodity analysts and some in the financial media to question the recent recovery in the gold price from USD1130/ozt to USD1230/ozt that occurred despite an increasingly more hawkish outlook for the nominal interest rates path and to proclaim that gold prices are bound to move lower as the Fed keeps raising rates.
However, when measured properly, regression analysis shows that gold prices are linked to real-interest rates rather than nominal rates. And sure enough, the correlation coefficient between real-interest rates and gold is currently also at very low levels. However, in a rare occasion, gold prices have moved closer with nominal rates than real rates over the past months.
We noticed that the link between real-interest rates and gold is often overlooked in the daily media reporting in favor of anecdotes about “flows” in the gold market (e.g. at the time of writing, the gold headline on Bloomberg is “ETF buyers see bargains as gold rally stalls on Fed view” 14 March, 2017). It appears that real-interest rates, even though clearly one of the main drivers of changes in the gold prices (see: Gold Price Framework Vol. 1: Price Model, October 8, 2015), are simply not enticing enough to report on. But nominal rates seem to be, hence the increased attention lately to the record low correlation between nominal rates and gold and all the wrong conclusions that come with it.
We believe that the reason why gold prices have recently moved closer in line with nominal interest rates rather than real lies in the Fed’s departure from near zero interest rates. For nearly 8 years, interest rates in the US were close to zero and the Fed has bought trillions of dollars in assets. As the Fed has been signaling for a while now that this period of unconventional monetary policy is coming to an end, it has sent seismic shifts through financial markets. The shifts in nominal rates are simply too large and dominate everything, hence the recent near-perfect negative correlation between gold prices and nominal rates.
Importantly however, there is no reason to believe that the fundamental relationship between gold and real interest rates that has existed for as long as data are available has changed. In our gold price framework we explained in detail why gold prices move with real rates and as long as gold is being regarded and used as a store of value, this relationship will hold. As we will explain, real interest rates are unlikely to sustainably exceed 1% in the coming years. The market’s reaction to last weeks FOMC rate decision illustrates that perfectly (see Chart below). Yes the Fed raised rates another 25bps, yet real-interest rates (or to be precise, real-interest rate expectations as measured by 10-year TIPS yields) declined and gold traded almost 2% higher. Gold prices in USD made their lows the day after of the first Fed hike in December 2015 and are up almost USD200/ozt, despite Fed Funds rates being up 75bps.
The Fed’s forward guidance aims at 3% terminal federal funds rate at the end for the hiking cycle (end of 2019), and taking the historical performance of both realized inflation and treasury yields into account that means real-interest rates have only little upside. In fact, we think the odds are increasingly to the contrary. The Fed can only raise rates to 3% over the next three years if the US economy doesn’t’ hit a roadblock on the way, but that would make the current cycle the longest period without a recession in US history. If the US does enter a recession however, the Fed’s room to maneuver will be extremely small. The current record period without recession was from 1991 to 2001 that ended with the bursting of the dotcom bubble and the Fed slashing rates by 5.5%. A similarly sized rate cut (which is about the average rate cut from the Fed in a recession) would push rates to somewhere around -2.5 to -5%, depending on how much the Fed had raised rates in the first place. Needless to say, real rates this negative would be extremely bullish for gold prices. In the meantime, we think gold prices will likely remain somewhat tied to nominal rates over the short run, which should offer good entry opportunities.
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