The above two charts, hold in inverse correlation, that is the 10-year inflation-indexed security yield moves inverse to gold prices. There are two components to treasury yields, the expected path of short term yields and inflation expectations. Treasury yields minus inflation expectations equal the expected real yield. In another way of saying it, the expected real yield is the portion of the treasury yield that is accounted for by the expected path of short-end yields and not inflation expectations. This can be seen in the chart below of all three variables.
The 10-year breakeven rate is a market based measure of inflation expectations. It is also the embedded expected rate of inflation into current 10-year treasury yields. In times of highly accommodative monetary policy, the 10-year breakeven or inflation expectations can surpass the 10-year treasury rate and this results in expected real rates going negative. Oppositely and more normally, the 10-year treasury yield will exceed the breakeven rate as there is another component, that is, the expected path of real short-end yields.
Higher short term yields tend to reverberate throughout the curve. When monetary policy is very accommodative and short-end rates are low and expected to stay that way or during QE, there is a lesser or zero effect of rising short-end yields embedded into the 10-year treasury yield. Monetary policy mostly influences the short end of the curve. Fed policy is pushing up the 2-year yield and the 10-year treasury market is starting to price in this shift in real short-end yields from negative to positive.
Expected real yields' inverse correlation with gold prices intuitively makes sense since gold is mainly an inflation hedge and struggles to compete when treasury yields rise because gold yields nothing. It is a matter of forecasting divergences or convergences in the 10-year treasury yield and 10-year inflation expectations or breakeven rate. When yields rise and inflation expectations fall or stay the same, it puts upward pressure on the expected real yield since it is the treasury yield minus the breakeven inflation expectation rate.
The nominal 2-year treasury yield minus the core CPI percent change gives the real 2-year yield, and it is moving into positive territory as shown above. This shift the expected path of real short-end yields is beginning to have an effect on longer-end yields, and this can be seen in the treasury sell-off going on right now.
The increase in inflation expectations is having less of an effect on 10-year yields than the expected path of short-end rates' influence. Inflation expectations are rising though the effect is less pronounced than other components. Inflation expectations have risen from 1.81% in September 2017 to 2.09% currently or 28 basis points. The 10 year yield, has risen from 2.06% to 2.70% or 64 basis points over the same time period. This equates to the expected real yield or 10-year inflation-indexed security yield increasing from 0.25% to 0.61% the equivalent of 36 basis points. Although both inflation and short-end yield expectations have increased, the latter is more significant. Gold prices are virtually unchanged from September 2017 at $1350 to now at $1348 despite the push higher in expected real yields. Last time expected real yields breached the 0.70% level was in December 2015 when the outlook for gold prices was very bearish and prices were at $1070.
Disclosure: I am/we are short WPM, ABX, GG, RGLD, FCX.
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