As a monetary metal, gold has been with humanity for thousands of years. Its role as a safe haven for wealth has been generally understood throughout time. Historically gold was simply another currency – one that couldn’t be debased and could reliably store vast amounts of wealth.
When thinking about gold, one must separate its value from its price. The value of gold is fairly stable. When compared to fiat currency, gold prices will fluctuate over time, but this is not because the value of gold is changing. Rather, it’s because the fiat currencies are appreciating or depreciating. For this reason, it’s important to analyze gold in terms of your home currency, despite it being most frequently quoted in USD. For example, the price of gold in USD might be stable but for a Canadian investor it might be rising because the value of CAD is declining. This relationship to currencies is an important first step to understanding what drives gold prices.
Many people believe inflation drives the price of gold. While this might be partly true (because inflation increases the value of tangible assets), it is inflation’s effect on currencies and investment alternatives that actually makes gold more attractive to investors.
Inflation will cause a country’s currency to depreciate relative to other currencies. As previously explained, in such a circumstance the gold price will rise in relation to a declining currency.
Equally important, inflation erodes the real returns provided by assets like stocks and bonds. In particular, safe havens like US Treasuries may provide a very low or even negative real yield when inflation is high enough relative to nominal yields. (Real yield = nominal yield minus inflation.) Importantly, this condition doesn’t require high inflation. Simply, inflation only needs to be higher than nominal interest rates.
Gold competes in many ways to US Treasuries as a safe haven. If investors can receive a positive real return on US Treasuries they are less likely to use gold – which provides zero yield – as a safe haven. The higher the real yield, the worse non-yielding assets look in comparison.
In contrast, when real yields on US Treasury bonds are negative, investors actually lose by holding them. A zero-yield actually becomes more attractive at that point.
Most gold bull markets have occurred when real yields were falling, low or negative. Gold bear markets tend to occur when real yields are rising, high or positive.
The Chart 1 below compares 1yr US Treasury yields (black line), inflation (red line) and real yields (blue line) going back to 1970. In Chart 2 below shows gold prices over the same period. As you can see in the first chart, real interest rates were falling, low or negative during the 1970s, but then began to rise around 1980. From 1980-2000 real interest rates remained positive and relatively high, until they began to decline at the turn of the century. Between 2000-2011 real interest rates were low and negative for most of the time. Leading into 2011, real interest rates began to rise and peaked around 2015. After 2015 real interest rates moved sideways again spending much time in negative territory.
How did gold perform during these periods?
1970-1980: Gold bull market
1980-2000: Gold bear market
2000-2011: Gold bull market
2011-2015: Gold bear market
2015-Present: Gold bull market
Chart 1: Nominal Yields, Inflation, Real Yields
Chart 2: Gold Price
While negative real yields might seem like an economic rarity, they occur quite frequently. As a matter of policy, negative real yields are often associated with periods of financial repression when governments are attempting to climb out from under the weight of oppressive debt levels. Essentially, when yields on government debt are less than inflation governments are able to ‘inflate’ their way out of debt. Because of inflation, the value of government assets and tax revenues are able to rise faster than the value of government liabilities and interest expense.
What does the future hold for real yields and gold?
While the world is currently working through a deflationary shock due to the Covid-19 shutdowns and collapse of demand, the monetary and fiscal response may push up the inflation rate and push down yields.
Note: I realize that the last time policy makers expanded the Fed balance sheet it failed to create any meaningful inflation. Long story short, I believe this time might be different because the US Treasury is increasingly involved, corporate debt is effectively backstopped by the Treasury and private banks are therefore much more willing to lend (thus increasing the money supply) than during previous crises.
Massive – and quickly growing – public and private sector liabilities have cornered policy makers. The only escape is secular financial repression to erode the real value of debts. Another option – default on debts and entitlements – simply isn’t politically palatable.
Therefore, it is reasonable to expect real yields to remain low-to-negative at least until the economy recovers from the current economic crisis. However, since debt loads are growing massively because of the crisis I can’t see any alternative but financial repression for at least a few years. Using the 2008/2009 global financial crisis as a rough guide, we may be recovering from this for years to come. the current gold bull market could last a few more years and gold prices could double from today’s levels.
Important note: I don’t have a crystal ball. Also, forecasts change as economic circumstances evolve. So don’t read this article and think you can set it and forget it. With an investment like gold that is so fundamentally different from the more traditional long-term asset classes, you must track the changing environment and adjust accordingly.