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Gold as yield play

The price of gold depends a lot upon real interest rates, which means it is insurance against some types of stock market decline
January 15, 2019

The gold price has hit a seven-month high in US dollar terms. It’s no accident at all that this has coincided with a rally in government bonds.

I say so because there has for years been a remarkably close link between the price of gold and the yield on five-year inflation-proofed US Treasury bonds: since December 2005 the correlation between the two has been minus 0.92, which is enormous by the standards of financial assets. Gold rose between 2005 and 2011 as real yields fell, fell between 2011 and 2015 as real yields rose, and rose in 2015-16 as real yields fell again.

From this perspective, it’s no surprise that gold should have rallied as real yields have fallen since the autumn.

There’s a simple reason for this link. It lies in that fundamental economic idea, opportunity cost. When we hold gold we are giving up the interest payments we could be getting on cash or bonds. The higher these payments are, the greater is the opportunity cost of gold. Which means that its price will be low: few people will want to hold the metal if doing so entails a big loss of income. As interest rates fall, however, so too does this opportunity cost and so gold becomes more attractive.

Herein lies the reason for gold’s recent rally. Investors’ appetite for risk has fallen since the autumn, causing them to try to dump equities in favour of safer assets such as bonds. And as bond yields have fallen, so too has the opportunity cost of gold, causing its price to rise.

Which reminds us of the great virtue of the metal. It protects us from some types of stock market fall. The sorts that see bond yields fall because of lower appetite for risk or fears about economic growth can see gold rise. It can therefore be a form of insurance against that type of equity market fall.

But of course, insurance has a price: you lose money if the event you’ve insured against doesn’t materialise. So it is with gold. There are two dangers here.

One lies in the Fed’s plan to raise real short-term interest rates: it foresees two rises in the fed funds rate this year but little change in inflation. In theory, gold and bond markets should already have discounted this prospect so they shouldn’t move if it materialises. But history warns us that even widely expected changes in monetary policy can sometimes upset markets: think of rates rises in 1994 or the 'taper tantrum' of 2013. Worse still, it’s possible that these rises will also hurt equities, which could mean that investors suffer losses on shares, bonds and gold at the same time.

A second danger is that we could see a diminution in the savings glut. One reason for the fall in real bond yields since the late 1990s is that high savings in Asia and the Middle East have forced yields down. But with oil exporters seeing falling revenues and China facing slower export growth, current account surpluses in these countries could fall. That would reduce the savings which have for years been invested in western bonds and so might raise yields.

These, however, are only dangers, not certainties. It’s very likely that the sustainable long-term real interest rate is much lower now than it was 20 years ago, thanks in part to an ageing population and slower productivity growth. Which means that yields need not increase much. John Roberts, an economist at the Fed, has estimated that since 2012 “the long-run neutral rate has averaged three quarters of a per cent, with little variation”. The five-year yield is now 0.9 per cent.

Granted, many economists are wary of the concept of an equilibrium real interest rate, and even those who believe in the idea acknowledge that it is hard to measure accurately. But one big fact suggests it is low – that years of negative real short-term rates did not trigger an inflationary boom. This fact alone tells us that the sustainable real interest rate might indeed be very low, suggesting that bond yields might not rise much at all.

Futurology, though, is not the reason for holding gold. Instead, as I say, its virtue is as insurance against a type of risk. And there is indeed a risk that bond yields will fall again if growth expectations or appetite for risk declines. We cannot quantify this risk, but it surely exists. And it is this that justifies gold playing a small part in investors’ portfolios.