WHAT DRIVES THE PRICE OF GOLD?
Excellent read here courtesy of Lone Pine Capital Ltd and Craig Stanley:
What drives the price of gold?
Craig Stanley, M.Sc.
Published 6/23/2009Currently, forward looking three-month and 10-year real rates are at negative 2.5% and 0.61% respectively. Though the outlook for gold is still positive given negative three-month real rates, there may be headwinds to the price making sustained moves above $1,000 an ounce until 10-year real rates move into negative territory
Nothing seems to generate such passionate debate and confusion within the financial sector as the role of gold. Is it an inflationary hedge? Can it go up during deflation? Is it a safe haven or antithesis to the U.S. dollar? Will the impending IMF sales flood the market?
What is lost in the debate is what gold represents — money. Gold is money that offers no yield (a negative yield after taking into account storage and insurance) and which is continually valued against fiat currencies that offer a yield.
Such a view was summed up best by Robert Barsky and Lawrence Summers in their article “Gibson’s Paradox and the Gold Standard” (The Journal of Political Economy, Volume 6, Issue 3. June 1999. p. 528-550).
“Gold is a highly durable asset, and thus…it is the demand for the existing stock, as opposed to the new flow, that must be modeled. The willingness to hold the stock of gold depends on the rate of return available on alternative assets.”
Hence I believe the fundamental long-term force driving the gold price is not mine supply nor jewelry demand, but real interest rates, specifically U.S. real interest rates on account of the U.S. dollar’s status as the world’s reserve fiat currency
In essence, real rates are calculated by subtracting inflation from benchmark interest rates. These benchmark nominal rates are derived from U.S. Treasury bills and bonds. (I use three-month and 10-year rates.) In keeping with the spirit of Fisher’s equation, expected inflation is the proper input. (I use the University of Michigan’s Survey of Consumers – one-year ahead inflation expectations.) Such a real interest is referred to as ex ante. Ex post real rates are calculated with a backward-looking inflation measure such as the year-over-year change in the Consumer Price Index for All Urban Consumers (CPI-U) as reported by the U.S. Bureau of Labor Statistics. (I appreciate the CPI is not perfect but its use does not take away from the point being made.)
Decreasing real interest rates are positive for gold as it lowers the opportunity cost of holding the metal. However, it is not a linear relationship. Instead, gold prices tend to significantly increase only if real rates become negative.
For example, the current bull market in gold that started in 2001 corresponds to U.S. three-month real rates falling below 0%.
Since President Nixon closed the gold window in 1971, there as not been one instance where U.S. three-month real rates fell below 0% that spot gold priced in U.S. dollars did not rise over the subsequent 12 months.
The last bull market in gold in the late 1970s and early 1980s corresponds to when three-month and 10-year real rates were negative on both an ex ante and ex post basis. Gold prices spiked in late 2007/early 2008 as 10-year real rates went negative, subsequently falling during the summer and fall of 2008 as these rates climbed into positive territory.
Given that relative real rates affect the value of a currency, it is no surprise that movements in one have a positive correlation with movements in the other. Since the last gold bull market, the correlation coefficient between month-end values of the U.S. Dollar Index and U.S. three-month and 10-year real rates have been around 0.57 and 0.69 respectively on both an ex ante and ex post basis. Conversely, the correlation between spot gold priced in U.S. dollars and the U.S. dollar index is predominantly negative (negative 0.42 since the 1970s), however the coefficient has fluctuated between positive and negative values hence investors should be cautious about using the direction of the U.S. dollar as short-term indicator for the gold price.
Thoughts and comments are always welcome. I know readers have an opinion on gold….
Richard Russell explains it very well:
http://www.investmentpostcards.com/2009/06/27/richard-russell-competitive-devaluations-to-spur-on-gold/
Gold is real money vs. paper money. Value of gold = inverse dollar(or substitute currency) value.
That is a good article, very good.
But gold is not simple INVERSE dollars (currency)
Gold is far more “foward” looking/speculating
Whereas the dollar is much more “current” whats happening RIGHT now
As we saw for a while there that swing divergance where BOTH were going up.
jmo, but the dollar is much more reactive, and gold is much more forward speculating. That is also due to the fact that the dollar is able to purchase things, hence the focus on on right now “real” time. Whereas gold trades on what “might be ahead”. That is why, really the ONLY reason at times there is a dislocation, is due to a bearish or bullish “speculation” in gold moving forward.
Gold is a stupid useless investment. It’s just a hunk of metal with no real value. I don’t get the obsession with it…
Provided gold price stays above 900, then gold producer stocks are far more profitable and liquid. AUY, IAG, GFI, GG are some good picks.
In my opinion gold is headed to 750…..as the next major stop
Erik:
EWI says the same. They see gold circa $650. They base such on a deflationary scenario.
Interestingly, studies show that gold performs better in deflation than inflation. So we will have to wait and see.
I admit that I have a downward bias for gold at the moment, yet there are many who believe that gold will explode upwards.
Sorry, but I’m not buying it. Since the price of gold was decontrolled at the end of Bretton Woods, we’ve had two major periods of appreciation: late 70′s and post-2001.
What both periods have in common — US political/military crisis, with the country either at war for a prolonged period, or at the brink of war.
Gold is ultimately a hedge against fear of US instability. Withdrawing from Iraq, combined with a policy that either keeps Afghanistan at a slow burn or else results in a decisive win, will be good for gold bears.
At this moment, gold is grossly overvalued. I would be holding it, with an eye toward selling it if it creates a new top above $1,000, but with the understanding that its days are numbered.
As a hedge, gold is not particularly stable, so the idea of gold being “safe” strikes me as being a bit nuts. As is the case with other commodities, it exhibits the sort of volatility that is associated with speculators who bid things up and down to excess. Track gold prices against inflation or dollar forex, and there is clearly no correlation, so I have no idea that anyone would argue that it does.
I don’t get the obsession with it
Gold attracts nutjobs the way that sugar water attracts flies. You can’t ignore the Paranoid People Factor in predicting short-term pricing. The fact that hucksters are peddling it on cable TV tells you that something isn’t quite right with a lot of what passes for gold “investing.”
I think this is brilliant and agree with what he is saying to a point but is he not taking into account the global economy i.e. value of the US dollar to relative to other currencies. I buy gold now because what I buy abroad will cost more when the currency devalues. Is this factor built into real interest rates or did he miss it?
Another factor driving the price of gold is the reserve currency status level, These are special times for the first time we have to add a psychology factor for faith in this case the dollar maintaining its world reserve currency status in to the equation.