Most investors and investment professionals have no clue how gold really works since they think of it purely as a hedge against inflation. To figure out how gold trades, investors have drawn comparisons to gold with the U.S. Dollar, cryptocurrencies, and even negative yielding government debt. The purpose of drawing comparisons is to find a way to profit from a change in the price of gold. While opinions about correlations vary widely, including its usefulness in a portfolio, most are wrong.
The purpose of gold has always been to protect investors against currency-printing inflation which plagues countries who do not have strong laws governing their central banks. Once the United States went off the gold standard, where the number of dollars in the system was limited to the amount of gold held in Federal Reserve banks, gold did its job to protect investors from the ensuing inflation of the dollar. Today, gold works a bit differently and investors who understand how it works can profit from it when the time is right.
Most investors believe gold trades inversely to the dollar as an inflation hedge, so when the dollar weakens, gold rises. If gold was a true hedge against the dollar, then it would always trade inversely, but there are times when both rise and fall together. The problem with drawing correlations is that monetary policy has changed over the years, which changes how asset classes trade in relation to one another. Gold is no exception.
Since the Great Financial Crisis, gold has tracked inflation-adjusted ten-year U.S. Treasury bond yields. When charting this relationship, gold needs to be inverted, but it is not a perfect relationship. However, it is the closest relationship I can find. The dollar does play a roll in how gold moves, but it is important to learn how gold traded prior to the Great Financial Crisis before examining how it trades today.
When President Nixon closed the gold window and decoupled the dollar from gold, gold rose to over $500 per ounce between 1971-82. Absent the gold standard, gold acted as an inflation hedge, just as it should. Without gold to anchor the dollar, interest rates became the primary regulator of the dollar, as interest rates rapidly rose between 1971-82, which many older investors remember as a period of high inflation.
After 1982, gold lost its luster among investors and lost about half its value going into the dot-com bubble. After the tech bubble burst, gold rallied for the next ten years from $250 per ounce to $1,500 per ounce. Once again, investors turned their attention to other asset classes and gold prices fell as the risks from the Great Financial Crisis were abated by zero-percent interest rates and massive rounds of Quantitative Easing.
Gold did not react to zero-percent interest rates and Quantitative Easing as many expected it to since the currency injected into bank excess reserves from Quantitative Easing never made it into the real economy. Had that currency been lent out, gold prices would have likely skyrocketed. As it turns out, Quantitative Easing inflates asset prices, but not the currency supply, which is why gold did not have a stronger reaction to the Fed’s monetary policy.
The strongest correlation to gold prices is inflation-adjusted ten-year Treasury yields when gold is charted inversely. This relationship started back in 1982 and has slowly strengthened in the decades following. Calculating inflation-adjusted ten-year Treasury yields is done by subtracting the year-over-year rate of change in the Consumer Price Index from 10-year Treasury yields.
Gold likes periods when inflation-adjusted ten-year Treasury yields are falling as consumer prices are rising, when yields are rapidly falling as consumer prices are falling at a slower rate, and when yields are rising at a slower rate than consumer prices are rising. Gold does not care for periods when yields and consumer prices are falling at the same rate.
Investors should always challenge their thesis to make sure they are right, and the best way to do that is to question why this relationship between gold and inflation-adjusted ten-year Treasury yields works. The Federal Reserve has two monetary policy tools they can use – the Fed can ease or tighten monetary policy, and gold prefers easy monetary policies.
The reason gold likes easy monetary policies is that lower interest rates are the only policy tool the Fed has that leads to an increase in the currency supply. Quantitative Easing should lead to an increase in the currency supply, but it requires consumers to own assets and the willingness to borrow against them. Since the Great Financial Crisis, fewer Americans own assets to borrow against.
The Fed’s policies can be broken down very easily. When consumer prices are rising too quickly, or there is the perception that they will rise too quickly, the Fed tightens monetary policy. When Treasury yields fall, which is a sign of tight financial conditions, the Fed tends to ease. All gold does is try to anticipate what conditions will cause the Fed to ease monetary policy and expand the currency supply.
When Treasury yields fall, it is a sign of tight financial conditions, which is why gold tends to shine when yields are falling faster than consumer prices. Gold figures out that the Fed is going to be forced into easing monetary policy before the Fed realizes they must ease. Gold also knows the Fed cannot let consumer prices rise when financial conditions are tight since asset prices tend to fall during periods of tight financial conditions.
In a debt-based economy, where consumers, businesses, and governments are encouraged to take on increasingly larger amounts of debt, falling asset prices lead to a financial crisis. When banks are holding loans against assets that are worth less than the amount lent out, borrowing comes to a halt and the financial system crashes.
The Great Financial Crisis is a perfect example of the inverse relationship between gold and inflation-adjusted ten-year Treasury yields when gold fell $250 per ounce between early and late 2008. The reason gold fell was that both interest rates and consumer prices were falling at the same rate. During recessions asset prices fall, which is why consumer prices fall during recessions as wholesalers and retailers are forced to lower prices to reduce their inventory levels, and why gold fell in value during the early phase of the Great Financial Crisis.
It was not until late 2008 that the Fed’s aggressive monetary easing policies started to drive the rate of inflation up faster than yields were rising. Once yields started to rise, they did not rise fast enough to catch consumer prices until 2011, which by then, gold had risen by almost $1,200 per ounce. Gold peaked in 2011 because ten-year Treasury yields continued to rise until early 2014, but consumer prices stopped rising shortly following 2011.
In June 2019, investors interpreted Fed Chair Powell’s post-FOMC press release to mean the Fed was going to be cutting the Federal Funds rate, and in response, investors drove gold prices higher. This is a false move since the Fed did not make any changes to monetary policy. Even if the Fed were to ease, the broad economy would not feel the effects for at least eighteen months and lowering rates by half-a-percent is not enough to cause consumer prices to rise faster than Treasury yields.
This relationship gives investors who understand it an idea of how gold is likely to perform during the next market downturn. Ten-year Treasury yields are on the edge of making a major move lower, and when they do, it will likely be a very rapid move lower.
Consumer prices should also fall, as wholesalers and retailers increased their inventory levels ahead of the tariffs but have not moved as much product as they hoped. It is unlikely that consumer prices will fall as fast as Treasury yields, which should send gold prices higher until Treasury yields bottom and consumer prices play catch up.
The U.S. Dollar does play a role in the price of gold. While there are times gold and the dollar move in sync, during periods where the dollar is losing value, gold tends to rise. A weak or falling dollar generally leads to consumer-price inflation, and for gold to outperform, all it needs is low or falling Treasury yields at the same time.
It will not be until the Fed is in a full easing mode trying to manage the next financial crisis before gold goes vertical. During the next financial crisis, the Fed will lower the Federal Funds rate below minus two percent with massive amounts of Quantitative Easing to rescue the economy from the deflationary shock that is normally associated with recessions.
Low and falling interest rates, along with rising asset prices, is the ideal environment for gold, which is why gold rose as high as it did following the Great Financial Crisis. Since the only way to take the Federal Funds rate deep into negative territory is by engaging in Quantitative Easing, the next Bull market in gold is only a matter of when the next recession turns into a full-blown financial crisis.
Addendum – Gold has been closely following 10-year Treasury yields for the past couple years and this relationship should be a guide for gold going forward. Since gold (shown inversely on a chart) follows inflation-adjusted 10-year Treasury yields, a closer examination of inflation can explain why gold is tracking Treasury yields. Since 2016 the year-over-year rate of change in the Consumer Price Index has been relatively flat at 2.1%. With inflation flat, it explains why the rise and fall of Treasury yields are dictating gold prices. There should be one meaningful move lower in gold, which should signal a buy as Treasury yields are likely to head lower. As far as consumer prices, the tariffs are artificially holding prices high.
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