Understanding the relationship between gold prices and real interest rates
We are told that the price of gold is primarily determined by real interest rates. This is true since 2008 (there was no quantitative easing before) and there is a theoretical explanation for it:
the higher the nominal yield, the lower the opportunity cost of holding gold (which does not pay dividends or coupon).
All things being equal, higher inflation (for which gold is supposed to be a good hedge), drives real interest rates down.
Real rates are often calculated on the basis of inflation expectations. They are derived from government bonds indexed to inflation (OTC:TIPS). The graph below shows several things:
Before 2008/09, before the implementation of unconventional monetary policies, the link between gold and real interest rates was nonexistent. Since then the relationship is particularly strong.
You can make a simple simulation based on two assumptions:
1. The U.S. 10-year rate falls to the zero bound, as in the case of Japan.
2. Expected inflation increases continuously (5 basis points per month) up to a maximum level of 5%.
Such a scenario would justify a price of gold close to 3 000 USD per ounce (see chart).
Once nominal yield reach the 0% bound, gold prices would depend on the ACCELERATION of inflation in the future. This is important: If you think the chart is valid permanently, then the price of gold may increase only if inflation increases continuously - or the price level continues to accelerate.
One major remark here: for expected inflation to reach 4/5% and, in the meantime, having no inflation risk premium embedded on the long end of the yield curve, you need a third factor: the underlying assumption of considerable expansion of the balance sheet of the Federal Reserve ($ 8 trillion?).
We can trace the same graph using not expected inflation (which can be skewed by problems inherent to TIPS liquidity) but observed inflation (you may justify this by considering that inflation expectations are sticky and mostly based on past inflation figures).
The relationship is less clear but seems to operate well between 2010 and today. This chart raises a major question: why did the price of gold not follow the sharp increases of inflation of 2008 and 2011?
The response of the economist is simple: because inflation responded to a transitory oil shock and / or thanks to the credibility of the FED in fighting inflation (transitory phenomena if the inflation targeting of the FED is deemed credible).
To conclude: there is a statistical link between gold prices and real interest rates. As nominal interest rates cannot fall below 0%, the rise in gold can only be, from a certain point, justified by perpetual increase in inflation (constant acceleration level general price). Such an hypothesis cannot be excluded if the Fed's balance sheet increases significantly and if the economy eventually respond (rise in credit, wages) to the stimulus.
Yet. The new 6.5% threshold for the unemployment rate set by the Fed and the reading of its latest Minutes suggest that it is doubtful that this is the most likely direction of U.S. monetary policy for the coming years. It is not insignificant that in 2012, gold has not followed the U.S. real rates so as linear as in the past. Otherwise the price would be 2000 and not 1650 as today.
If you want to be right ion where gold is heading, forget real rates and focus on the USD!
Disclosure: I 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.