Miserable markets love gold, but caution advised on its latest rally

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Gold, finally, is enjoying a bit of good news, thanks to general misery and a Swiss surprise.

After the alpine nation shocked markets on Thursday by scrapping its currency ceiling with the euro, the precious metal climbed 2.2 per cent. The latest gains continued the bounce it has been on for the past couple of months, even as other commodities such as oil and iron ore have plunged.

Some observers believe the yellow metal is poised for even better things ahead. "Gold is on a stealthy rally and I suspect gold is going to be headed higher not lower," Jeff Gundlach, the widely quoted CEO of DoubleLine Capital, said earlier this week.

But investors should be cautious about playing this rally. While there's a strong case to be made that gold is on an upswing, the size of that upswing appears limited for reasons that have more to do with bond yields than gold mining.

One of the biggest drivers of gold prices is the real rate of interest, which is roughly equal to the amount that an investor could earn, after inflation, on a government bond. As real interest rates go down, gold prices tend to go up.

This odd relationship makes sense if you remember that gold pays no interest and produces no dividends. As a result, investors who buy the precious metal know they're giving up – at the very least – the safe, guaranteed yield they could otherwise earn on a government bond. Gold bugs figure that passing up the secure yield makes sense because they're convinced that the metal will rise in price and produce lush gains that dwarf the paltry payout from bonds.

Maybe so – but the tug of war in investors' hearts between gold and bonds will change depending on how much the investor is giving up in terms of safe, guaranteed yield. If real interest rates are high, the so-called opportunity cost of holding gold is high and the metal is less attractive. But as rates go down, gold becomes more attractive, since investors are giving up less in exchange for holding the metal.

It's no great surprise then that gold has prospered as bond yields have plunged in recent weeks. Fears of a slowing global economy, combined with indications of slumping demand for key products such as oil, have wrestled 10-year government bond yields in Germany and Japan to historic lows and kneecapped North American bond yields as well.

Misery is good for gold, which as economist Paul Krugman notes, "is something people buy when real returns on alternative assets are low." But the question investors have to ask now is how much higher gold can go when real interest rates are already hovering around zero or even below.

Gold's path from here will depend on investors' demand for a haven from a slowing global economy and turmoil in the currency markets. On Thursday, the Swiss central bank stunned markets by scrapping its cap on the franc-euro exchange rate. Within hours, the Swiss currency surged as much as 39 per cent against both the euro and the U.S. dollar.

The cap had pinned the currency at 1.20 francs to the euro for more than three years, but Swiss policy makers appear to have concluded that the cost of maintaining the cap would be prohibitive if the European Central Bank goes ahead later this month, as expected, with a plan to spur its economy by creating massive amounts of euros to purchase euro zone government bonds. To maintain the cap, Switzerland would have had to be prepared to create huge amounts of Swiss francs and use them to buy euro-denominated bonds.

The Swiss switch will leave many investors wondering how far they can trust any central bank. Just last month, the Swiss National Bank was still declaring the currency cap to be untouchable.

Distrust of central banks may lead to more demand for gold. In a note earlier this week, Julian Jessop of Capital Economics estimated that demand for a haven is likely to drive the price of gold from its current $1,261.20 (U.S.) per ounce to $1,300 by the end of this year and $1,400 by the end of 2016.

As you might note, the potential gains don't seem huge – and even then, Mr. Jessop added a note of caution. "We are still wary of getting carried away," he wrote, adding that "gold prices could simply drop back again as, and when, global risk appetite returns." For now, gold seems more risk amplifier than risk reducer.