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Author: Jan Nieuwenhuijs
Correlation between dollar gold price and 10-year TIPS yield
There are three noteworthy periods to understand the current gold price model. The first period is Bretton Woods: an international monetary system that existed from 1944 to 1971, in which the U.S. dollar officially functioned as the world's reserve currency and was backed by gold at a price of $35 per troy ounce. Shortly after World War II, there was little doubt about the dollar's stability. In the 1960s, however, the market concerned about a devaluation of the dollar against gold, because the Americans printed too many dollars. The market had to make a trade-off between holding gold—the only international reserve that cannot be arbitrarily devalued but has not yielded—and holding U.S. Treasuries, which yielded but were denominated in dollars. Treasury interest rates and expectations of a devaluation of the dollar played a role in the market's decision to buy or sell gold.
The second period began in 1968, when the dollar was decoupled from gold in the free market. Investors fled to gold as a safe haven, driving up the price of gold in the process, as they expected that Inflation would rise (and ex-post real interest rates would fall). When the U.S. central bank raised interest rates and inflation fell (and ex-post real interest rates rose), investors sold gold causing the price of gold to fall. Hence the inverse correlation between gold and ex-post real interest rates from 1968 to 2005. Treasury interest rates and inflation expectations played a role in the market's decision to buy or sell gold.
10-year Treasury ex-post real interest rate versus gold price
After negative ex-post real interest rates in the 1970s, the gold price did not fall back to the level it was when real interest rates were positive, reflecting the depreciation of the dollar. For more graphs see Part One*.
The third phase began in 1997, when Treasury Inflation Protected Securities (TIPS) were introduced in the United States. That led to the birth of ex-ante real interest rates. A few years later, in 2006, the price of gold became closely correlated with the 10-year TIPS yield.
The TIPS rate is the expected real interest rate. The TIPS interest rate formula is:
Expected Real Interest Rate = Treasury Rate – Inflation Expectations
In other words:
TIPS Rate = Treasury Rate – Breakeven Rate
Falling TIPS yields push gold higher; a rising TIPS rate is driving gold down. Treasury interest rates and inflation expectations play a role in the market's decision to buy or sell gold.
To explain why I think the current gold price model is unsustainable, we will take a closer look at how TIPS bonds work in the next chapter. If you are already familiar with this matter, you can go directly to the conclusion.
Let's start with some bond market basics. According to the renowned Treasury investor Lucy Hunt the standard for valuing nominal government bonds is the Fisher equation:
Risk-free rate = real interest rate + inflation expectations
In other words:
Treasury Rate = Real Interest Rate + Inflation Expectations
The Treasury rate is considered risk-free because the U.S. government can print as many dollars as it wants to pay off its debts. The refunded dollars may be worth toilet paper, but they will most likely be refunded. Based on the Fisher equation, investors decide whether to buy Treasuries or not. (Here's how it works in theory, in reality many financial institutions are forced by law to to buy government bonds.)
A nominal Treasury bond with a maturity of 10 years and a coupon (interest rate) of 3%, will pay 3% of the principal amount in interest annually, and after 10 years, the principal will be repaid. If inflation turns out to be higher than the lender expected, and he holds the bond until maturity, it will reduce his real return.
TIPS bonds »guarantee" investors a real return. For example, an investor buys a 10-year TIPS bond with a principal amount of $1 million dollars and a coupon of 2%. With each coupon payment, the principal amount of the bond is Adjusted for inflation, which also corrects the coupon payment. At maturity, the U.S. Treasury will repay the investor $1 million dollars, adjusted for 10-year inflation. Thus, the investor receives 2% interest per annum and gets back the principal, both in real terms (adjusted for inflation).
Why don't all bond investors want to hold TIPS bonds? The answer to this question is simple. Because TIPS bonds are compensated for inflation, the market will buy up these securities, causing their yields to fall relative to nominal Treasury rates, until the return to the investor is comparable. Therefore, the difference between the TIPS rate and the nominal Treasury rate is called the "breakeven rate". And the breakeven rate serves as an indicator of market-based inflation expectations. If the market expects annual inflation to average 1% over the next 10 years and the 10-year nominal Treasury rate is 3%, then the 10-year TIPS rate will be priced at 2% (3% – 1%).
Since the TIPS rate is considered the (ex-ante) real rate, the TIPS bond formula is a realignment of the Fisher equation:
TIPS Rate (2%) = Treasury Rate (3%) – Inflation Expectations (1%)
Treasury rate (3%) = real interest rate (2%) + inflation expectations (1%)
When the market's inflation expectations turn out to have been accurate at maturity of TIPS bonds, they will have generated the same real yield as nominal Treasury bonds of the same maturity. The main reason to own TIPS bonds is because they outperform nominal Treasuries during an unexpected rise in inflation. As a result, TIPS bonds are widely used to hedge interest rate risks associated with nominal Treasuries. Logically, nominal Treasuries perform better when inflation is lower than expected.
What happens if the TIPS interest rate is negative? First, it is impossible to get bondholders to pay periodically. In order to impose a negative return, the buyer must pay a premium in advance on top of the principal. A higher price for a principal returned in the future is the same as a negative return. If the 10-year TIPS interest rate is –1%, the buyer pays about 110% of the principal and gets 100% back after ten years. During the life of the bond, 100% of the principal amount is adjusted for inflation, without coupon payments**; At maturity, the investor has lost 1% per annum in real terms.
Is the current gold price model sustainable for a long time? To answer that question, we will test the logic of the model.
Below is a chart showing the inverse correlation between the gold price and the 10-year TIPS yield.
10-year TIPS interest rate versus gold price
From 2006 onwards, the gold price went up when TIPS interest rates fell and vice versa. We have to conclude that it becomes more attractive for the market to own gold when real interest rates fall, because gold is the only international reserve with no counterparty risk.Gold can't possibly go bankrupt.
Falling TIPS yields (the bond market expects earn less in real terms) is offset by a rising gold price. But strangely, the correlation doesn't change when the TIPS rate enters negative territory. When the TIPS rate falls from -0.5% to -1% (the bond market expects More to lose in real terms), the gold price reacts the same as when the TIPS rate falls from 1% to 0.5%.
Even stranger, if the 10-year TIPS yield in the current model were to remain at -1% for years, the bond market would accept immense losses, but the gold price would remain at $1800 dollars all the time. No compensation. This doesn't make sense according to my analysis.
A final point to think about concerns the fact that the U.S. federal debt is growing much faster than the above-ground gold supply. In the last ten years, this debt has doubled, while the above-ground gold supply has increased by 17%. Now consider that in both 2012 and 2022, the TIPS interest rate was –1%. So, in 2022, the total expected loss of the U.S. bond market in nominal dollars is twice what it was a decade ago, while the nominal price of gold—the price of a quantity of gold that has risen 17% in 10 years—is the same as it was a decade ago. The current model seems to be asymmetrical.
It is likely that the 10-year TIPS yield will remain negative because the total debt-to-GDP ratio in the US is at an all-time high of 370% (the national debt is at 120%). In this situation, the U.S. government can hardly allow nominal interest rates to climb much higher. Meanwhile, money printing and supply chain issues have unleashed inflation.
I think the longer the TIPS rate remains negative, the more likely it is that gold will "decouple" and rise further. Another important factor here is that in many countries, savings deposits at the bank have been bearing a negative (ex-post) real interest rate for years. As a result, investors have embraced stocks and real estate as "the perfect store of value," as these assets continue to rise and pay dividends or rents. Previously, I wrote about why I think these asset markets are moving into a bubble (here and here). When they eventually snap, investors will look for an alternative store of value. Where to flee to when stocks plummet and government bonds can't offer positive real returns? Historically, gold has functioned as the primary resort.
*I made a mistake in a chart published in part one, although the error has no analytical consequences. The percentages on the right-hand axis in Graph 5 (a comparison of year-on-year consumer price changes with year-on-year gold price changes) had to be multiplied by a factor of 10. The graph has been corrected.
**In reality, the minimum coupon payment is 0.125%. Because, I think, of technical reasons. When the TIPS interest rate is negative, these coupon payments are factored into the premium paid in advance.
H/T Brain Romanchuk
Sources
This article originally appeared on The Gold Observer
