Cloud Hosting

amedved/iStock via Getty Images

Gold has become a very controversial asset class in recent years. The precious metal is often seen as an obsolete asset in the so-called new 'exponential era' (whatever that means) and also tends to be ignored during periods when it performs well as a hedge against risk & uncertainty within the financial system.

In reality, however, gold and SPDR Gold Trust ETF (NYSEARCA:GLD) in particular are doing exactly what they are supposed to for investors who are willing to look beyond quarterly performance and simplistic narratives.

In spite of all the criticism and talk about rising interest rates, since my last analysis on GLD called: 'Gold: Still Haunted By Misconceptions', the ETF still outperformed the market on an absolute basis.

However, short-term performance doesn't really matter for anyone, who like me is aiming for long-term results. That is why, since my first analysis entirely focused on gold, called "Why Caution Is Required As Never Before And The Case For Investing In Gold", the GLD has significantly reduced volatility when combined with an equity portfolio.

Therefore, contrary to many popular beliefs, gold has been an excellent addition to my equity portfolio, it improved my returns and above all - performed just as I expected it would.

Since this performance is now in the rear-view mirror, we should first address the elephant in the room and what has become a very simplistic and popular belief out there: interest rates are about to increase and as a zero-yield asset, gold prices should fall.

For anyone who has been following my work, it should come as no surprise that I do disagree with this statement for a number of reasons.

Of course, one could easily fall for this narrative, by simply observing the graph below which depicts the price of gold versus the market yield on the U.S. Treasury Inflation-Protected Securities, or TIPS.

fred.stlouisfed.org

To an extent it is true that the price of gold is inversely related to the level of real interest rates. But to understand just how important the risk of rising real interest rates for the price of gold is, we must answer a number of questions:

The answer to the first question will almost always remain speculative. Predicting where real interest rates will be 5 or 10 years from now is a futile exercise. The level of interest rates needs to normalize, in order to reduce certain systemic risks that are now too large to be ignored. However, given the amount of public debt relative to GDP and the twin deficit (both fiscal and current account) does not allow for a meaningful increase in interest rates.

fred.stlouisfed.org

To put it briefly, it appears that real interest rates cannot increase meaningfully, however, making investment decisions based on such forecasts will be largely speculative and not prudent.

More importantly, we should answer the second question regarding the inverse relationship between gold prices and real interest rates.

Firstly, we should widen our time horizon in order avoid issues related to data mining. Unfortunately, data on TIPS yields from the Federal Reserve Economic Data (FRED) goes back to 2003 only. In the graph below, we have the yield on TIPS plotted on the left-hand side versus the inversed price of gold on the right.

Prepared by the author, using data from fred.stlouisfed.org

At the moment (as of 25th of January) the yield on TIPS stands at a negative 0.63%, while the spot price of gold is around $1,836 per ounce. Back in September of 2012, the yield was once again at a negative 0.63% while the price of gold was at $1,709. This is a very wide variance which is visible in the gap between real yields and the price of gold in the graph above that varies over time.

Another way to present the data above is by plotting TIPS yield on the x-axis and the price of gold on the y-axis.

Prepared by the author, using data from fred.stlouisfed.org

At first the relationship between the two variables appears very strong. However, at the bottom right-hand corner of the graph we see that the inverse relationship could actually turn positive. Therefore, if we isolate the period between April 2003 (which is when the data starts) and December 2007 (right before the crisis and the unconventional monetary policy that followed), we see that the relationship is in fact positive.

Prepared by the author, using data from fred.stlouisfed.org

If we use data on real interest rates provided by the World Bank and take a longer term view (still within the current monetary regime), we see that the relationship between the two variables is far less stable over the long-term. For example, during 1982 to 1999 period, both gold price and real rates declined significantly.

Prepared by the author, using data from fred.stlouisfed.org and data.worldbank.org

Indeed, in the next 20 years that followed (see below) gold's price increased as interest rates fell, however it is hard to justify a constant and yet strong negative relationship between the two.

Prepared by the author, using data from fred.stlouisfed.org and data.worldbank.org

All that clearly illustrates that the relationship between gold and real interest is subject to change over time and that trends seen over the past decade are unlikely to have any predictive power for the future.

As we saw above, during the 1980 to 2000 period both gold prices and real interest rates fell. This could be explained by the increasing Velocity of M2 Money Stock during the period which reached one of its highest levels around 2000s.

fred.stlouisfed.org

If we take the 1990s decade for example, we had rising velocity of M2 in conjunction with very low growth of M2.

fred.stlouisfed.org

* percentage change from year ago

Inflation was also under control during the decade which suggests that the real economy was strong and growing over the period, without any extreme financialization.

fred.stlouisfed.org

* percentage change from year ago

This setup resulted in low demand for gold even as both real and nominal rates were falling.

fred.stlouisfed.org

This clearly illustrates how gold and interest rates could both move in unison, provided there are the right monetary conditions for it.

Contrary to the 1990s, however, velocity has been falling for the past 20 years and reached one of its lowest levels in recent years due to the sharp increase of the monetary base following the pandemic. Ample liquidity and falling velocity has been one of the reasons why financial assets have been performing so well during the past 20 years, while real assets suffered. Should this trend reverse its course, we could witness both real rates and precious metals increasing.

In addition, to the relationship between gold and interest rates being subject to change over time, there is another very important driver of the precious metal's price. More specifically, gold performs exceptionally well during periods of change, risk and uncertainty for the existing monetary system. That is why gold performed well during the 1930s when the gold standard was abandoned. The precious metal's price also increased significantly in the years following the end of the Bretton Woods system. As we are likely approaching a new monetary regime shift, the risk-reward profile of gold once again appears attractive. I explain all that in further detail here.

Gold is hardly an asset that is appealing to the broader retail investment community nowadays. With plenty of exciting opportunities in the tech sector and all the hype around crypto currencies, it is hard to see a perception shift towards gold. However, this is largely a result of decades of loose monetary and fiscal policies, which provided all the incentives needed for the risk-seeking behavior we witness today and the proliferation of unprofitable enterprises. This financialization of the economy has been a significant headwind for gold even as real rates fell well into the negative territory. As we reach peak levels of financialization and pressure for a reset on the current monetary regime looms higher, the long-term set up for gold appears attractive just as sentiment is at one of its lowest levels.

Read the original here:

Gold And Real Rates - The Narrative Bias - Seeking Alpha