What determines the price of gold? (Part 1)

Author: Jan Nieuwenhuijs

In general, the price of gold in U.S. dollars is determined by long-term inflation expectations and interest rates in the United States. The price of gold in another currency depends on the exchange rate between that currency and the dollar.

After we discussed how the international gold market works in a previous series of articles, in this series we will investigate which economic variables influence the supply and demand of gold, and thus the price of gold. To save you valuable time, I will start this article with a summary and the historical background. In the following parts, we will cover the details.

In my opinion, it is important to understand the current model, if only to question its longevity.

Since 2006, the price of gold in U.S. dollars has been correlated to real interest rates, derived from the 10-year Treasury Inflation Protected Security (TIPS), as you can see in the chart below. I call this correlation the current model.

Gold Price vs TIPS Rate

Please note, in the chart above, the axis of the TIPS rate is reversed, because when the TIPS rate falls, the gold price rises and vice versa*. The reasoning is that when real government bond yields fall, it becomes more attractive to own gold, because gold is the only international reserve with no counterparty risk. If real interest rates rise, it becomes less attractive to own gold, because gold does not yield a return (if it is not lent).

The 10-year TIPS bond is a U.S. Treasury bond that compensates its owner for consumer price inflation (CPI). For example, if the TIPS interest rate is 2% and the annual inflation rate is 3%, then the owner of the bond will receive 5% interest (2% + 3%). Because a correction is added when the interest and principal are paid, the market sets the TIPS rate lower than the interest rate on regular U.S. Treasuries (nominal Treasuries). The market will continue to buy TIPS bonds, lowering its yields, until the market is indifferent between holding TIPS bonds or nominal Treasuries, based on expectations about average inflation over the next 10 years.

TIPS Interest Rate vs. 10-Year Treasury Rate

Thus, the difference between the 10-year TIPS rate and the 10-year nominal Treasury rate is what the market expects the average inflation rate to be over the next ten years. This market-based inflation expectation is also known as the break-even rate.

Summarized:

TIPS Interest = Treasury Rate – Break-Even Interest

In other words:

Expected Real Interest Rate = Treasury Rate – Inflation Expectations

To which I can add that after 2008, the 10-year break-even rate has become more closely correlated with the oil price. Energy is the lifeblood of the economy, and when energy prices rise, it translates into higher prices of consumer goods, we might argue.

10-year breakeven interest rates and oil prices

For those who want to consult an interactive chart showing gold price and the 10-year TIPS yield, you can here click. Click here for an interactive chart showing the 10-year break-even rate, the 10-year TIPS rate, and 10-year nominal Treasury rate.

A Historical Perspective on Gold as a Store of Value

Gold has been an insurance against inflation for thousands of years. Although gold is not a perfect constant, because there is no such thing in the economy.

People in the Far East still have the habit of giving their friends and family gold at the birth of a child or a marriage. This ancient tradition ensures that local communities survive all monetary regimes by using gold as a store of value and distributing it among themselves upon reproduction. They had learned early on that money spent by the government eventually loses its purchasing power. To pass on a piggy bank from one generation to the next, a store of value is needed that cannot be printed and is unchangeable: gold.

In developed economies, people have somewhat lost their affinity for gold, as the financial revolution started earlier in the West, allowing higher returns on wealth to be achieved. It must be said that Western central banks have held on to their huge gold reserves. Ironically, they are fully aware of their shortcomings and hold gold as the ultimate reserve.

The graph below shows the depreciation of three fiat currencies against gold, without interest rates being charged. After all, many people have little or no savings that generate interest.

Depreciation of fiat money vs gold

During the last version of the gold standard (Bretton Woods), the U.S. dollar was pegged to gold at a price of $35 dollars per troy ounce. All other major currencies were then pegged to the dollar. Technically, Bretton Woods ended in 1968 when the Americans decided to decouple the price of gold from the dollar in the free market, after printing too many dollars and the gold peg had become unsustainable. From that moment on, the price of gold started to rise. Once again, it was clear that no government-issued currency can compete with gold.

It is worth noting that in the 1970s, the price of gold often rose before consumer prices rose. If the market expected inflation to rise, investors would take refuge in gold, and the price skyrocketed. Thus, the gold price became a reflection of inflation expectations. If the price of gold rose, consumer prices followed within two years.

Change in consumer prices and gold prices

The head of the U.S. central bank, Alan Greenspan, Said in 1994:

"I think what the price of gold reflects is a picture of the desire to hold hard assets against currencies... [The price of gold] is a measure that has shown a fairly consistent lead over inflation expectations, and over the years has been a pretty good indicator of, among other things, what inflation expectations are doing."

 Greenspan based its interest rate policy on even partially on the price of gold.

 The link between inflation expectations and the price of gold is still relevant, as we saw in the introduction to TIPS bonds.

After the 1970s—with skyrocketing inflation and deeply negative real interest rates—investors were lured out of gold in the 1980s by high positive real interest rates. Because there were no TIPS bonds before 1997, the real interest rate could only be calculated as the nominal interest rate minus the most recent inflation rates. Academics call this the ex-post real interest rate, while at the TIPS rate the ex-ante real interest rates.

The chart below shows the 10-year (ex-post) real interest rate, calculated as the 10-year nominal Treasury rate minus inflation in the United States from 1968 through 2021. The interest rate axis has been reversed again.

 Real interest rates and gold prices since 1968

It should be clear that the real interest rate is very important for the gold price. In the 1970s, the price of gold skyrocketed when real interest rates fell twice to -5%. Could that happen again if the current inflation turns out not to be temporary and real interest rates remain in deep negative territory for an extended period of time?

In search of answers, in part 2 we will take a closer look at how TIPS bonds work, among other things.

*Footnote: In this article I have only indicated the correlation, the article does not contain any evidence to prove causality.

This article originally appeared on The Gold Observer