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Bond yields falling, gold rising: What’s going on?

Investors looking to predict the future course of gold prices should watch the U.S. bond market carefully. It wasn't supposed to be this way.

Historically, the investment value of gold was an "anti-currency" way to preserve spending power while inflation eroded the value of non-gold backed currencies, notably the U.S. dollar. The gold price soared, for example, in the late 1970s when inflation was rampant.

In the conventional case, the price of gold rises with inflation and so do bond yields. Inflation expectations are embedded in bond yields so that the more inflation pressure is evident (and expected in the future), the higher bond yields go. From 1976 to 1981, for instance, the U.S. five-year bond yield went from 6.1 per cent to 16.1 per cent while gold prices more than tripled from $134.50 (U.S.) per ounce during the same period.

If gold performs well with rising inflation then the bullion price should be falling in the current market environment rife with deflation fears and declining bond yields, right? Nope. Instead of gold falling with bond yields it's doing the reverse – rising in almost exact proportion to the extent bond yields fall.

The accompanying chart shows this new market phenomenon. It's important to note that the U.S. five-year bond yield is plotted inversely on the chart to better show the trend – a rising grey line indicates falling bond yields. So far in 2016, the five-year U.S. Treasury yield has fallen more than one half of a percentage point from 1.76 per cent to 1.31 per cent. The bullion price has climbed 17 per cent to $1,241.80.

The somewhat counter-historical trend of gold prices benefiting from deflation concerns can be explained by two factors – opportunity costs and central bank credibility.

Gold's opportunity costs are related to the fact that bullion does not generate income, profits or cash flow. So, in periods where equity markets are extremely profitable, or inflation-adjusted bond yields are high, gold is less attractive to investors and the bullion price tends to underperform other asset classes. In the current environment, equity market profit growth and real bond yields remain very low by historical standards. Gold investors are not forgoing much "opportunity" in equity or fixed income markets.

In terms of central banks, there are growing concerns cited by major research firms like Citi and Credit Suisse, that loose monetary policy is no longer an effective means to generate economic growth. To some extent, this leads to fears that central banks, and the major currencies they defend and support, are losing control. Many investors are looking to the relative haven of gold to protect their currency-denominated wealth against the possibility of devaluation.

Stability in global equity, fixed income and currency markets would likely dent gold's current popularity. Specifically, a significant rise in the U.S. five-year bond yield would result in a sell-off in gold if current patterns persist. But in a market environment driven by increasingly unprecedented central bank policy and slow growth, bullion will always have its supporters.

Follow Scott Barlow on Twitter @SBarlow_ROB.

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