Singapore (29 July 2020) — Gold has been surging ahead. Having broken through the USD 1,900/troz level on Friday – a level not seen since 2011 – its now making its way to the USD 2,000 mark.
What factors move the yellow metal?
When looking to determine the direction of gold prices, there are a multitude of things that we can look at: the US dollar, inflation, interest rates, the demand for safe haven assets, etc. One of the strongest predictors of gold prices has been that of the inverse relationship between the price of physical gold and real interest rate. Why is this? This is because real interest rate is derived using two important elements among those mentioned earlier as strong predictor of gold prices: inflation and nominal interest rates.
Inflation and Nominal Interest Rates
Inflation has a positive correlation with gold as the yellow metal is seen as a store of value in times of where inflation is rampant. On the other hand, nominal interest rate is seen as having a negative correlation with gold. Higher nominal interest rate makes gold less attractive given that it does not provide dividends or any fixed returns, and yet incurs storage cost. Given this dependency solely on capital gains, gold is seen as an opportunity cost to investors in an environment where interest rates are high.
Nominal vs Real Interest Rates
So, what is real interest rate? In general, real interest rate refers to the nominal interest rate that is adjusted for inflation. For example, if the nominal interest rate is 5% and inflation 3%, the corresponding real interest rate is 2%. The actual formula for determining real interest rate is a bit less straightforward but as a rule of thumb, by and large, the equation that is widely used is:
Nominal Interest Rate minus Inflation = Real Interest Rate
For nominal interest rates, the market typically uses longer-term benchmark rates such as the US Treasury 10-year bond or even 20-year UST bond. But in essence, nominal rates can refer to any tenure along the normal yield curve which quotes interest rates on a nominal basis (non-inflation adjusted). For inflation, the traditional measure is either Consumer Price Index or Producer Price Index. With these two, one can arrive at real interest rates.
Proxy to real interest rate: TIPS
In today’s market, participants typically turn to an instrument called Treasury Inflation Protected Securities or better known as TIPS. TIPS are similar to the traditional bond except that it’s principal will be adjusted to account for inflation. Thus, when traded on the secondary market, the yield-to-maturity of a particular TIPS is a reflection of market’s inflation expectations. To put it simply, the yield on TIPS is largely considered to be the real interest rate.
Gold & Real Interest Rates
When one puts gold prices side-by-side with real interest rates, it becomes apparent that there exists a very strong negative correlation (Chart 1). This is because what drives down real interest rates (lower nominal interest rates and higher inflation), conversely drives up gold prices and vice versa. Chart 2 better reflects this by using an inverted TIPS versus actual gold prices.
Prospect of lower real interest rates
Going into the next 2 years, at the very least, the prospect is for real interest rates to potentially head lower from current levels (& thus higher gold prices). Central banks globally have already signalled that they will keep their monetary policies loose and are unlikely to raise nominal interest rates any time soon. On the other hand, yields on many bonds in the market place are gradually nudging lower to reflect the economic realities. But it is a sharp increase in inflation that could surprise to push real interest rates deep into negative territory. With supply chain disruptions, higher cost of doing business and economies re-opening again, the odds of rising consumer or producer prices is gradually building up. In summary, one of gold’s primary indicator is suggesting we could see price of the yellow metal remain well supported over the next 12-24 months.-/-
Disclaimer: Mr Sani Hamid is a Director (Economy & Market Strategy) with financial advisory firm Financial Alliance and a Certified Financial Planner. He contributes to www.halaluniverse.net on a regular basis. The views, opinions and information expressed in this article are purely Mr Sani’s and don’t necessarily represent the views of Halal Universe. Mr Sani’s views in this article are not to be construed as financial advice. Investors should seek advice from a financial adviser before investing.
