Looking at the downside pressure on real yields it is premature to predict the end of gold’s rally.
By Aasif Hirani
Gold is one of the major asset classes which have given positive returns year-to-date. The recent bull run has still room to go and many investors are asking what is driving the prices? Covid-19 is one of the reasons but that is not the only reason.
We are still in the early stage of the bull run with gold giving the best quarterly returns since 2009. The big question in everybody’s mind is how much more can gold go from here and also what will drive the prices higher in the future.
If the Covid-19 vaccine comes, then everybody is expecting the equity market to rally and gold market to retrace. But one of the important things is that despite the vaccine, the damage that Covid-19 has done in four months will take a couple of years to normalise. Recently in the US, the New York Fed president said that it will take a couple of years for the US economy to come at pre-Covid-19 levels. Central banks will keep interest rates low and quantitative easing, as well as bond buying, will continue for at least a couple of years. One of the factors that everybody is missing out is the building of inflationary pressure because of easy money pumping by central banks.
Gold prices and real yields
The correlation between gold prices and real yields (interest rate minus inflation) are opposite where when real yields go up, gold goes down and vice versa. When interest rates increase, real yields also increase, enhancing the value of the US dollar by making it higher-yielding assets which are bad for gold and so gold prices come down. But in a scenario where real yields are low, then investors are not foregoing any opportunity cost for holding gold thus making US Dollar an unattractive asset and enhancing the price of gold.
We have analysed two real yield proxies, i.e., 5- and 10-year inflation indexed treasuries (TIPS), which shows that gold prices and inverted TIPS yield are tightly linked. Since 2020, the correlation has strengthened—gold and 10 year TIPS posted 0.79 correlations while prior to 2020 it was 0.59. A correlation of 1.0 indicates a perfect positive correlation. Part of the reason why the correlation has strengthened is interest rate and inflation have both declined due to the Covid-19 crisis. The US Fed is expected to keep interest rates low till 2022 and markets are flushed with monetary supply. By cutting interest rates to near zero and buying not just government treasuries but also corporate bonds to the tune of trillions of dollars, the US central bank has made it clear that the ultra-dovish policy is here to stay for an extended period.
The five-year TIPS has been negative much of the year except for the spike on March 11 to March 24, 2020, when it jumped to 0.01 before crashing back below 0. At present, the five-year TIPS is at -0.86, an eight-year low.
This trend is very bullish for gold given the historical record vis-à-vis real yields. The future is uncertain but looking at the downside pressure on real yields it is premature to predict the end of gold’s rally. Intermediate top may have been made looking at a sharp upside rally but a probable target of $1825-$1875 is still open because ultra-ease monetary policy will increase inflation and interest rate is going to be near zero thus pushing TIPS further in negative territory.
The writer is director, Tradebulls Securities