The gold price has surged 16 per cent year to date in Canadian dollar terms but, as always with precious metals, there are no price to earnings or price to cash flow valuation levels to help investors measure the sustainability of the rally.
There is, however, a lesser known indicator that has successfully predicted the gold price: U.S. inflation adjusted interest rates.
There are two reasons why the current gold rally is difficult to analyze. One, it is occurring against the backdrop of a strong rally in the U.S. dollar. Historically, the bullion price has moved in the opposite direction of the greenback.
Second, and more positively for gold investors, the fact that gold does not generate earnings or cash flow is much less of a problem in a world where big chunks of the global bond market are paying negative yields, meaning that instead of rewarding investors for buying their bonds, they charge them for it. The opportunity cost of holding gold is much lower relative to Swiss government bonds, for example, because at least with gold, investors are not guaranteed to lose money the longer they hold it.
This week's chart details the one relationship that has provided an accurate guide to the future course of the bullion price. The chart compares the gold price to the five year maturity U.S. Treasury Inflation Protected Security (TIPs). The five year TIPs is a government security designed as a "real return" bond – trading with a yield equal to the five year U.S. Treasury bond, minus the inflation rate.
SOURCE: Scott Barlow/Bloomberg
Backed by correlation analysis, it's clear that the gold price and five year TIPs have been moving consistently in the opposite direction for the past 24 months. Most recently, the rally in bullion coincided exactly with a sharp fall in TIPs yields, from 0.47 per cent to a negative yield of 0.17 per cent.
Investors are accustomed to the idea that gold protects portfolios from inflation – the bullion price rises as inflation devalues the spending power of the U.S. dollar. Lately, however, the reverse has been true. By moving in the opposite direction of inflation-protection, the gold price has been climbing as deflationary pressures become more evident in lower U.S. and global bond yields.
As long as current patterns persist, the gold price should rally when U.S. Treasury bond yields fall. Rising U.S. yields, conversely, are likely to cause a correction in bullion prices.