One reason for gold's fall is that investors are anticipating higher returns on bonds and cash, as the Federal Reserve is expected to raise rates later this year. Rising interest rates often imply a falling gold price simply because they raise the opportunity cost of holding the metal. When bond yields and cash rates are high, we forego big returns on safe assets if we hold gold, and so gold becomes less attractive when yields rise.
For this reason, there has been a strong negative correlation between annual changes in the gold price and in the yield on five-year Treasury Inflation-proofed securities (TIPS, the US equivalent to index-linked gilts). This has been minus 0.5 since TIPS were launched in 2003, but even higher than this since 2007. Rising real bond yields have been accompanied by falling gold prices, and falling yields by rising prices.
Now, consider two scenarios.
In scenario one, interest rates return to their pre-crisis levels. This would imply real yields increasing from 0.1 per cent now to over 2 per cent.
In scenario two, secular stagnation intensifies - perhaps with western economies falling into recession - which would return real yields to negative territory.
Given the correlation between gold and real yields, scenario one would see gold fall and scenario two would see it do well.
But here's the thing. Scenario one is a world in which investors are otherwise doing well. Returns on cash would be improving, and the same economic strength that permits rates to rise would probably increase earnings expectations and appetite for risk, causing shares to do well. Scenario two, by contrast, sees lower returns on cash and equities.
In this sense, gold offers insurance against secular stagnation. As real interest rates fall, gold would probably rise, thus offsetting poor returns on cash and equities.
Of course, insurance comes at a price. That price would be further falls in gold if the threat of secular stagnation recedes. But in this event, losses on gold would be cushioned by gains on equities and better returns on cash.
It’s for this reason that gold has a (small) place in portfolios. It helps protect us against a nasty risk, while potential losses on the metal should be easily bearable because of gains on other assets.
