Gold has gained momentum, with a 7.5% increase in dollar terms since the beginning of the year. The rise is clearly well explained by the rise in TIPS following the bull flattening of the Treasury curve and the associated fall in oil prices.
I would spare you my favorite chart of gold against U.S. real yields, since it tells the same story. More interestingly, and as can be seen below, there is a significant link between the gold price in EUR (XAU/EUR) and European real yields (I take the spread between Bund yields and Eurozone inflation).
Over the past few years, the value of XAU/EUR has been closely tied to European real yields. As can be seen above, the fall in the XAU/EUR was well explained by the rise in real yields in 2013 and 2014, which can be explained by the disinflation trends recorded there, coupled with the timid adjustment of the ECB - which was, of course, hampered by the zero bound on its repo target.
The link has broken down over the last few months with an accentuation of the gap, first after the SNB decision, and again when the ECB announced the details of its quantitative easing program.
Today's situation would clearly call for mean reversion, since the real yield implied level of XAU/EUR stands at 800, not 1140 as it is today. It could come through:
- A sharp fall in real interest rates. For this, either yields continue to fall, or inflation increases. The ECB might help, but only marginally, since it started buying at a time when yields were already very low. Of course, the Swiss case shows us that nominal yields are not floored by the zero bound. But the extent of the required adjustment in nominal yields suggested by the discrepancy between the gold denominated in Euro and European real yields would rather suggest mean reversion would call for a dramatic rise in Eurozone inflation over the next few months.
- Another reading of the chart is that gold prices are too high when denominated in EUR. Here also, one basic interpretation would be that gold prices simply have to fall. As we said above, we do not see any significant mispricing for gold prices in dollars. The adjustment may thus rather call for a strengthening of the EUR/USD. This is clearly in line with my view that the EUR/USD is unlikely to fall below parity.
The chart below sums it up: The current level of the EUR/USD is completely at odds with real yield spreads. There are, of course, factors that can explain the current valuation of the pair, such as the relative growth rates of Fed and ECB balance sheets, but European real yields would have to be much more lower to justify the current level of the EUR/USD. If we compare this analysis to the fact that gold in euro is too high given the current level of European real yield, both suggest the EUR should be stronger.
Bottom Line: If you believe, as I do, that gold prices are driven mostly by real interest rates, the current disconnect seen in XAU/EUR would call for several adjustments in the Eurozone:
a. Higher inflation moving forward
b. Lower nominal yields ahead for 2-year sovereign bonds (those short-tenor papers are not included in ECB's QE, but are clearly affected by the fact that QE is here until at least September 2016
c. A higher EUR/USD
Given that (a) and (b) are clearly unlikely (or at least the extent of the decline in nominal yields deep into negative territory is limited), and given that there is no mispricing in the XAU/USD, the current valuation of gold in EUR suggests that the EUR/USD is too low. This is confirmed by the real yield spread between the U.S. and the Eurozone.
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