Richard (Rick) Mills

Ahead of the Herd

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As a general rule, the most successful man in life is the man who has the best information

Gold’s Price

Ahead of the Herd readers know I believe gold’s price is being driven by rising, or falling, real interest rates.

Real interest rates are the level of annual yield paid to savers and investors over and above the pace of inflation.

PIMCO makes a convincing case that the number one factor influencing the price of gold is the changes in real yield on 10 year US Treasuries.

“Based on our study, the regression shows that, all else equal, a 100-basis-point increase in 10-year real yields has historically led to a decline of 26.8% in the inflation-adjusted price of gold.”

Chasing Yield

When real interest rates are low, at, or below zero, cash and bonds fall out of favor because your real return is lower than inflation – if your earning 1.6 percent on your money but inflation is running 2.7 percent the real rate you are earning is negative 1.1 percent – an investor is actually losing purchasing power.

So gold’s price is tied to low/negative real interest rates which are essentially the by-product of inflation – when real rates are low, the price of gold can/will rise, of course when real rates are rising, gold can fall very quickly.

Interest rates matter, they matter a lot. They affect the cost of borrowing for homes and business investment. They effect the rates paid on deposits and savings and also set the risk-free rate of return which is important for assessing returns from other asset classes like shares, bonds, precious metals, commodities and property.

According to PIMCO:

“Today the marginal price of gold is largely set by financial demand, as over $70 billion of gold is held by ETFs, and investors choose to buy or sell gold ETFs by comparing the expected real return on gold to that of other liquid financial assets.” PIMCO

The world’s dominant gold Exchange Traded Fund (ETF) is the American SPDR Gold Shares. The SPDR had the largest outflow of any single ETP in 2013 at $25 billion.

Commodity exchange traded products (ETPs) suffered their worst year on record as assets under management (AUM) declined by $78 billion to $122 billion in 2013.

Total ETP gold holdings declined to 56.67 million ounces at year-end from 84.62 million at the end of 2012. ETF Securities estimated that of the roughly $71 billion gold AUM decline, 46% was caused by a 28% fall in the gold price and 54% by investor outflows. The decline in overall commodity AUM was the most on record.

PIMCO’s advice for gold investors is the following:

“As gold increasingly becomes a financial asset, when real yields rise, gold prices should fall if they are to maintain a given level of financial demand relative to investors’ other opportunities. Similarly, when real yields fall, we expect the price of gold to rise. Investors should be aware of the relationship between gold and real yields because it has important implications for how they think about the role of gold in their portfolio in an asset-allocation and risk-factor framework.” PIMCO

What does PIMCO expect for short term gold prices?

“Looking ahead, we expect the Federal Reserve to move very gradually in reducing accommodative policy and for 10-year U.S. real yields over the next several months to be relatively steady around current levels, which would be neutral for nominal gold prices.” PIMCO

According to a recent economist survey by Bloomberg the three-month Treasury bill rate will be 0.42 percent and the yield on the 10-year Treasury note will be 3.33 percent by the end of 2014.

The Bank of Nova Scotia, in its January 30th 2014 ‘Global Forecast Update’ predicts U.S. 10 year Treasury rising to 3.40 percent Q4, 2014 and to 4 percent Q4 2015.

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