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What's driving down the price of gold? Blame it on rising interest rates.
As a general rule, the price of the precious metal moves in the opposite direction to U.S. real interest rates. (Real interest rates strip out inflation to reflect the true cost of borrowing money. If the quoted interest rate at your local bank is 5 per cent and inflation is running at 2 per cent, the real rate is 3 per cent.)
The accompanying chart tracks U.S. real 10-year rates against the gold price since 1975. Over that entire period, the correlation between real rates and gold prices is negative 0.34, indicating that the two have displayed a weak tendency to move in opposite directions. This is interesting, but hardly a Eureka moment.
However, when rates turn volatile, the relationship between gold prices and real rates becomes far stronger. For instance, between July, 1975, and May, 1980, the correlation reached negative 0.87 – as real rates dropped during this period, gold soared.
And more recently? The correlation from October, 2009, to the present is an equally compelling negative 0.85.
There are at least three reasons why gold prices tend to zig when real rates zag.
First, rising real rates imply that inflation is either stable or declining. This is bad for precious metals prices, because fewer investors want to hold gold as an inflation hedge during such periods.
Second, rising real rates usually indicate stronger economic growth. In an expanding economy, investors want to buy growth-oriented stocks; they don't want to merely protect the value of their cash by holding bullion.
Finally, rising real rates increase the opportunity cost of holding gold. Bullion, unlike bonds, doesn't produce any stream of regular payments, and there are usually costs associated with holding it. In deciding to buy gold, an investor is passing up the cash she could have had from buying a bond and collecting its payouts.
In 2011, when real yields on U.S. Treasuries were negative (the nominal yield was lower than the inflation rate), bonds weren't appealing. An investor was giving up little or nothing to sell bonds and buy gold.
Now the situation is different. Real bond yields are positive, and the positive real returns from bonds are harder to ignore. It's easy to understand why many investors appear to be selling gold and buying bonds instead.
In the short term, the price of gold can be affected by factors other than rates. Over longer periods, however, the gold price is unlikely to do well when U.S. real interest rates are improving. Investors who believe U.S rates will continue to move higher should stay well away from gold – at least until inflation pressure builds.
Editor's note: An earlier version of this story said that between July, 1975, and May, 1980, rates soared and gold plunged. In fact, as stated above, real rates dropped and gold soared during this period.