The price of gold has recently hit a 17-month low. In large part, this is because it has been a victim of President Donald Trump.
Gold has fallen as US bond yields have risen, at least in real terms: the five-year inflation-proofed Treasury bond yield has hit a nine-year high. This is no accident. The two have been closely negatively correlated for years; rising bond yields are usually accompanied by a falling gold price, and falling yields by a rising one.
There’s a simple reason for this: opportunity cost. A dollar spent on gold is a dollar not spent on cash or bonds. When you hold gold, therefore, you are giving up returns you could have had on those assts. When bond yields and interest rates are low, this sacrifice is small and so demand for gold will be high – as, therefore, will be its price. As real interest rates rise, however, the sacrifice of returns on cash and bonds becomes greater. In effect, gold becomes more expensive to own, and so its price falls.
This reason for gold to fall has been reinforced by another – the rise in the US dollar.
Such rises have traditionally tended to cut the price of gold. Again, the reason is simple. If the dollar rises, gold becomes more expensive in terms of euros, yen and so on. Non-US investors can therefore afford less of it, which of course causes its dollar price to fall.
It’s perfectly normal, therefore, for gold to fall as the dollar and real interest rates rise. Which poses the question: why have they done so?
This is where President Trump enters the story. He is loosening fiscal policy. The OECD expects that US government borrowing will rise from 3.6 per cent of GDP last year to 6.1 per cent next. All of this is a policy relaxation, not a response to a weak economy. (In fact, the economy is expected to continue growing nicely.) A looser fiscal policy often means higher bond yields and a stronger currency as investors anticipate higher short-term interest rates. So gold suffers.
It might suffer more. So far, this prospect of increased borrowing hasn’t much changed inflation expectations: markets still expect consumer price inflation to average less than 2 per cent per year over the next five years. If this belief proves too optimistic, and if low unemployment does eventually trigger rising inflation then real interest rates will rise by more than the market currently expects, so bond yields will rise further, to the detriment of gold.
You might think that, in this event, gold would benefit because it should be a hedge against rising inflation. Not necessarily. The link between gold and consumer price inflation is weak: gold’s price was much higher in the late 1990s when inflation was low than in the 1980s when it was high. That between gold and interest rates is much stronger. As the latter rise, therefore, gold should fall.
Is this a reason to sell gold? I’m not sure. The case for holding a little of the metal has never been dependent upon some forecast of the future. Instead, gold’s virtue is that it’s a way of spreading risk.
And there’s one particularly nasty danger that gold might help protect us from – recession. The fact that gold does well when bond yields fall means that it should do well in recessions. This is especially useful because equities get clobbered then: this was certainly the case in 2008-09.
Of course, a recession doesn’t seem imminent; if anything, the opposite. But recessions are usually unpredictable, except perhaps by the shape of the yield curve (and that with a variable time lag). Which means we should not try to forecast them but rather insure against them. Gold offers such insurance.
Yes, this insurance is expensive; there’s a chance gold will fall if we don’t get that recession. But this is a problem we’ve had for years – that expected returns on insurance assets (cash, bonds and gold) are low. There’s no avoiding this awkward fact.
