The Skeptic's Simple Case For Gold

| About: SPDR Gold (GLD)

Summary

The price of gold is highly correlated (inversely) to real interest rates in the U.S.

With no end in sight for worldwide monetary expansion, it is reasonable to expect real interest rates to continue to decline.

Negative real interest rates in the U.S., Europe and Japan provide a compelling rationale for precious metals exposure.

There are many voices in the precious metals markets, and the majority of the voices are bullish. Many prominent gold bulls also have items for sale: books, newsletter or trading subscriptions, advertising clicks, and gold and silver bullion.

The sales pitch for precious metals is often cloaked in dire warnings and/or calls for action to prepare for apocalyptic scenarios. Overall, the selling style of gold bugs may cause skeptics to ignore the message.

We admit up-front that our lexicon does indeed include the phrase "fiat currency." After separating the wheat from the chaff, we now pay for a couple of high-quality subscription services that provide perspective on the precious metals markets. And we own vaulted precious metals with Goldmoney (OTC:XAUMF).

But this paper is not intended to convince the reader of any of these things. This paper is written for the beginner, or skeptic, who may tune out the precious metals message because of its ubiquity and tone.

A Correlation Between Gold and Interest Rates

Since the financial crisis of 2008, the price of gold has moved in tight (inverse) correlation to the U.S. 5-year inflation-indexed treasury bond (the 5-year TIP). Since 2008, rising real interest rates have been coincident with a fall in gold prices. Declining real interest rates have been coincident with a rise in gold prices.

As a quick review, the "real interest rate" is the "nominal interest rate" minus the rate of inflation. If the interest rate is 3%, and the inflation rate is 2.5%, then the real interest rate is 0.5%. The 5-year TIP provides a ready proxy (in a market security) for real interest rates.

Our basic thesis is this: if real interest rates are in decline, we will expect the price of gold to rise. In addition, we expect that negative interest rates will result in investors shifting assets allocations from bonds and cash to precious metals. It would be perfectly rational for them to do so.

Click to enlarge

Sources: TradingView and Quandl.

In addition to showing the correlation between real rates and gold, this graph helps to provide perspective on these asset classes following the financial crisis. In early 2008, during the peak of the mortgage crisis, the 5-year TIP whipsawed down to 0%, before rocketing above 4%, before settling back near 1.5% by the end of the year. Moving in an inverse relationship, the price of gold surged to a new high near $1,000 per ounce in March 2008, before retreating to a $700 per ounce when U.S. interest rates spiked in late 2008. Gold was not the "safe haven" trade in mid- to late-2008.

Since the financial crisis, central banks around the world have all worked in overdrive to protect the financial system and stimulate economic growth. In December 2008, The U.S. Federal Reserve began its Quantitative easing ("QE") program. Over the next several years, this program along with market forces pushed real interest rates lower, and the 5-year TIP reached a low near -1.60%. During the same 2009-2012 period, the price of gold rose from a low near $860 to a high near $1,920 per ounce.

Click to enlarge

Source: TradingView, Quandl and Wikipedia (for QE dates).

As the U.S. QE and Operation Twist programs drew to a close in 2013, the 5-year TIP rose from -1.5% to 0%, and the price of gold fell. And during 2014 and 2015, real interest rates continued to climb as gold continued to fall.

In early 2016, the economic outlook dimmed (perhaps in conjunction with the Fed raising rates in December 2015), and the 5-year TIP began a descent into negative territory again. Most recently, the 5-year TIP fell in yield from -0.05% on September 13 th to -0.31% on September 28 th, 2016, following the Fed meetings. This fall in real rates may turn out to be a resumption of the downward trend which began in early 2016.

The big decline in the 5-year TIP in late September may be related to the published Fed governor future expectation for rates (as expressed in the "dot plots"), which were more dovish than previous. In addition, the Fed has recently suggested that they may seek U.S. congressional approval for more "monetary tools."

To be clear, we aren't suggesting that the 5-year TIP, per se, is the leading indicator of gold prices. In fact, short-term real interest rates are actually lower than 5-year rates, and may provide more of a proxy for investment decisions. Nevertheless, the 5-year TIP is the shortest term TIP that is sold by the U.S., and therefore is perhaps a clear proxy to support our general thesis.

Continued Central Bank Expansionary Policies

In 2014 and 2015, the The European Central Bank ("ECB") and the Bank of Japan ("BOJ") took the monetary expansion baton from the Fed, and have both embarked on ambitious QE and Negative Interest Rate Policies ("NIRP"). Both the ECB and BOJ have said that they will do "whatever it takes" to spur economic growth and inflation. As an aside, it baffles us that central bankers will explicitly target inflation rather than economic growth, but that is a topic for another time.

The BOJ surprised the financial markets by announcing NIRP on January 29th, 2016, and gold rallied thereafter from $1,100 to $1,200 in less than 2 weeks. Recently, the BOJ announced its version of Operation Twist, with an explicit target of 0% nominal interest rates for the 10-year Japanese bond.

At the moment, we see slowing GDP growth everywhere, and the European banking system is facing headwinds that some market participants view as potentially systemic risks. Meanwhile, worldwide debt levels continue to grow (in some cases exponentially), as worldwide economic growth remains elusive. Based upon these factors, we anticipate that highly accommodative policies will remain in effect for the BOJ, the ECB, and for the Fed for the foreseeable future.

A Tangible Asset Inflation Example

Let's assume four people are seated at a table and each person has $20 to spend. In the room, there are four items up for bid:

  1. A one oz silver coin;
  2. 10 gallons of gasoline;
  3. 30 apples; and
  4. A bottle of whiskey.

Each player can bid for whatever item they want, or all of the items, up to $20. Now, I know you are chuckling because you just decided to bid $20 for the whiskey.

In any case, let's assume that five years later, each player now has $30. What will be the bid clearing value of each item? We suggest that each item will likely have risen in price from $20 to $30. Here is the point: continued printing of (unlimited) currency will likely raise the price of all tangible, finite assets. To take the example a step further, a person who decided to save their $20 cash at the beginning will 5 years later have less purchasing power for these tangible goods, and in fact the additional $20 would likely raise the clearing price of the four items to $35.

We believe that it is rational to invest in tangible, finite assets in an era of seemingly infinite monetary expansion. But don't take our word for it. Find out why successful investors like Stanley Druckenmiller, Jeffrey Gundlach, David Einhorn, George Soros and Bill Gross are investing in precious metals.

Summary Thoughts

There are many voices in the precious metals markets. While we hesitate to add to the noise, we hope that our overall thesis has been clear, particularly for the skeptic, beginner, or unconvinced.

Since 2008, the price of gold has risen and fallen in a close relationship to real U.S. interest rates. This relationship makes sense in a low or negative interest rate environment. If the value of one's currency is guaranteed to decline over time, then precious metals may provide a superior store of value in comparison to cash or treasury bonds.

There are many options to consider when investing in precious metals. If you are just getting started, then we encourage you to continue your research. The GLD and SLV exchange traded funds might be good places to start. Physical bullion, vaulted by professionals, would be the safest next step to take in our view. But, let's cover one thing at a time. Good luck to all.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: We are long shares of XAUMF, and also have positions in some precious metals mining stocks