With The Wall Street Journal once again playing down any precious metals strength and Goldman explicitly saying “sell,” RBC Capitalo Markets’ Tyler Broda and Alexandra Slattery are considerably more positive…
Retro Gold – Are we heading back to the 1970s?
Gold is often considered as a strong hedge for inflationary environments. The 1970s are the most commonly cited example of this phenomenon (in the US at least). Our analysis suggests that inflation is only part of the equation. As US inflation begins to re-emerge, and monetary policy around it continues to remain accommodative, the potential for lower real interest rates, at least over the medium-term, is increasing. In our view, this could create similar dynamics for the gold market as what occurred in the mid-to-late 1970s.
The recent statements from the Chairwoman of the US FOMC, Janet Yellen, suggest that global risks and the lack of central bank firepower in a low interest rate environment will likely mean that interest rates will be held lower for longer. In her speech to the Economic Club of New York in March, Ms. Yellen stated that the neutral “real Fed funds rate” (the level at which monetary policy would be neither expansionary nor contractionary) is likely close to zero. When using the core PCE measure, the current rate at -1.25% is even lower. In addition, concerns are beginning to mount for the FOMC that inflation may be coming unanchored to longer-term stable levels but to the downside. This implies the probability for lower real interest rates is likely to increase. This change in stance, and the market’s anticipation of this outcome following significant global market volatility in January/February, have helped to spur what appears to be the first sustained gold ETF buying since 2011.
Gold’s two key characteristics determining rates of investment (the most price insensitive demand category) are:
1) Positive – its ability to hold (or increase) in value through periods of market volatility and economic downturns and it is slightly Beta negative to the broader markets.
2) Negative – its lack of yield.
In a normal environment, when inflation expectations are positive, but contained or falling, real interest rates (nominal rate – inflation) have tended to be positive. In an environment such as this, the cost of owning gold is equal to this real interest rate or what is being given up vs. other yielding assets (after inflation).
In the 1970s, when inflation and inflation expectations ran sharply higher, there was little that could be done from a monetary policy perspective, as any hikes in interest rates would have meant a serious recession (not to mention the impact from other external shocks). In this environment, where accelerating inflation caused real interest rates to fall below the neutral 2% level (after moving sharply negative for a time), gold rose from ~$125/oz in 1976 to a peak of ~$800/oz in 1980.
Since 2008, the correlation between gold and real interest rates (using 10 yr US bond yields and 5yr5yr inflation swaps as a proxy for medium-term inflation) has been high. The Rsquared is 60%, with higher correlations in periods of rapid movements in real rates. This high correlation makes logical sense in a period of lower interest rates as well as lower inflation expectations. In 2012-2013, the expectations that monetary policy was on the cusp of normalising (or at least normalising over the longer-term) saw a sharp recovery in real interest rates and a declining gold price. This coincided with the sharp selloff of gold ETFs in 2013. Real rates are now trending back down again along with an increase in gold ETF demand and the gold price.
Determining the correct methodology for calculating real interest rates is difficult (in fact there are many different real rates across the curve), but for the purposes of this analysis we have used the US5yr inflation swaps as the expected level of inflation and we are using the US 10 year treasury yield as the long-run interest rate.
Based on a regression analysis holding gold as the independent variable, a negative 0.5% real rate level would suggest a gold price of $1,380/oz and a negative 1.0% real rate level would suggest a gold price $1,546/oz. (Currently, we would calculate this real rate proxy as -34bp, which implies a gold price of $1,326/oz). The potential for inflation rates to move upwards and match US Treasury yields, which continue to be held down in the short-term, could create a 1970s-esque phase in real rates, in which our analysis suggests could move gold prices higher from here. We have published a global gold update increasing our price forecasts for 2016 to $1,250/oz and from 2017 onwards to $1,300/oz.
Gold investment appears to be moving towards stronger fundamentals than we have seen over the past few years.
In summary, should US monetary policy not be on the path to normalization, a fundamental change in the benefit of gold ownership is taking place, and this increased investment demand should lead to higher gold prices. There is increasing upside risk to gold prices.
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As @TheChartMeister notes, sometimes a picture helps…
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