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Gold Versus Real Rates: $1,380+ by May Day 2019

Commentaries & Views

Declining 10-year real rates set the stage for higher gold prices in 2019

The first-half of 2019 will be a push-pull to higher $1,380+ gold prices underpinned by a trend of higher lows. This outlook is based on a weakening U.S. dollar and real interest rates that have peaked for the near-term against a volatile backdrop of Washington and geopolitical uncertainty.

Over the last five years, gold has been negatively correlated with 10-year real rates 71% of the time. This is reassuring given the popular assumption about opportunity cost for holding a gold position – the higher real rates go, the more costly to keep a non-interest bearing asset like gold. Falling real rates support rising gold prices and vice-versa. Less often, more dominant drivers are at play and gold price appears insensitive to changes in real

rates. The low gold price volatility from mid-April to late-September is a good example. Over this time, the yellow metal behaved as a currency. It was highly correlated with the Chinese yuan; to a lesser degree, the euro and yen; and much less, to real rates.

Which case will be true for the first half of 2019?

The correlation of gold price and real rates

This analysis defines "real rate" as the inflation adjusted interest rate of a U.S. 10-year Treasury note. It is is computed by subtracting the 10-year breakeven inflation rate, also known as the 10-year inflation expectation, from the Treasury note interest rate. Both sets of data are available on the Federal Reserve Bank of St. Louis Economic Research website (FRED Economic Data).

Figure 1 is a scatter plot of 1- and 3-month rolling correlations of the 10-year real rate and Comex gold for the past five years:

Figure 1 – Correlation Scatter Plot

As demonstrated by the density of data points in the lower-left quadrant, 1- and 3-month negative correlations occur simultaneously 71.7% of the time.The case where both correlations are positive occurs much less frequently, only 7.5% (upper-right quadrant). Data in the other two quadrants represent correlations of different signs suggesting a transition from the lower-to-upper regions or vice versa. For example, a pesistently positive 1-month correlation will eventualy turn a 3-month negative correlation positive (i.e. a transition from lower-right to upper-right quadrant).

Time histories of gold and real rates

Figure 2 illustrates gold and real rate structures over the same five year period. 2016 is a textbook example of negative correlations at work. Note real rate peaks and dip into negative territory (A,B & C) and the corresponding opposite reaction in gold price. During the 2018 Chinese yuan correlation, a peak in real rates (X) seems to have little consequence (i.e. peaks are followed by a rise, not a continuing decline, in gold price for 2016).

Figure 2 – Comparison of gold and real rate structures

2019 appears to poised for another 2016-type setup (note point A' of peak real rates followed by a rise in gold prices). This works if inflation outpaces the rise in nominal rates. For example, a bad outcome in upcoming U.S./China trade negotiations could unleash inflationary pressures and slower U.S. growth could dampen 10-year Treasury note rates. Taken together a falling real rate is possible.

A strong U.S. dollar has kept gold in check for 2018 but this may be fading. The U.S. dollar index peaked in early December has retreated to just above its 200-day average. Falling below

this average would be consistent with a slower economic growth outlook and a Federal Reserve that is expected to slow rate hikes in 2019. The shadow of soaring deficits may also start to eclipse dollar strength.

Another hint at higher gold prices ahead may be the old adage "the bigger the base, the higher in space." As shown in Figure 2, gold has been trapped between $1,050 and $1,400 for a long, long time. A rally to $1,380 by May is a first step in breaking out of this channel.

Happy New Year!

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