Guest Post: The Key Relationship Between US Real Rates And Gold Prices

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Submitted by Sam Kirtley of SK Options Trading

The Key Relationship between US Real Rates and Gold Prices

Gold investors tend to focus overwhelmingly on the relationship
between the US dollar and gold, citing that a lower dollar leads to
higher gold prices in US dollars. Whilst this may be generally true,
there is another relationship that does not get as much attention as we
believe it deserves, and that is the relationship gold has with US real
interest rates. For the first few years of this gold bull market, it was
sufficient simply to acknowledge the USD down, therefore gold up
dynamic, but now things have changed. Over the past couple of years gold
has rallied when the greenback has been making gains, as well as when
it was weakening, therefore investors must now take note of the inverse
relationship between US real interest rates and gold, which has been
observed consistently over the last couple of years.

us 5yr real rates vs gold sk options trading

basic fundamentals behind this inverse relationship are that when US
monetary policy is looser, real rates fall and therefore investors buy
gold for a number of reasons. Firstly, lower real rates could imply
higher inflationary expectations in the future therefore gold is bought
as a hedge against this possible inflation. Secondly, lower real returns
in Treasuries drives investors into risk assets in search of a higher
return. This also sends gold higher but it also sends most commodities,
risk currencies and equities higher too. Thirdly, lower real returns on
Treasuries reduce demand of US dollars, causing the dollar to fall and
therefore the gold price to rise in US dollars. Finally, looser monetary
policy implies that the economic situation is not as rosy as many would
like to believe, so if the Federal Reserve acts by loosening monetary
policy and driving down real interest rates then that send a message
that the economy is in a bad place therefore investors buy gold as a
safe haven asset. There are probably many more reasons for this
relationship, but we have just tried to cover the main ones.

us 7yr real rates vs gold sk options trading

Whilst this inverse relationship is not perfect, it does have a distinct
theoretical advantage over simply watching the USD versus gold
relationship as sometimes both US dollars and gold can be in demand as
safe haven assets. For example if there were to be a crisis, such as the
recent sovereign debt issues in Europe, money would flow into gold in
search of a safe haven, but also into dollars to escape the European
issues. Investors would sell European bonds driving their yields higher,
and buy US bonds driving their yields lower. Gold would be rising and
the US dollar would be rising, negating their usually negative
correlation. However US rates would be falling as investors bought
treasuries as a safe haven and therefore the inverse relationship
between gold and US treasury rates would hold firm.

us 10yr real rates vs gold sk options trading

The theoretical aspects of this may all be well and good, but what
really matters to investors and traders such as ourselves is how these
theories can be applied in the real world, and how effective they are in
producing profitable signals to trade from. So here is a practical
example of how we applied and profited from this relationship in the
real world. In late August 2010 we noticed that US real rates were
falling far more rapidly that gold prices were rising. We also held the
view that the Federal Reserve was going to embark on another round of
quantitative easing within the next three months, therefore we did not
see US real rates rising, given that the Federal Reserve would likely
begin buying bonds heavily. From this we inferred that gold prices we
set to stage a major rally to a new all time high, so signalled to our
subscribers to buy a great deal of out of the money GLD call options to
benefit from this rise (more details can be viewed in our full trading
records, which is published on our website). We banked profits in
percentage terms, ten times higher that the gains made by gold or the
HUI gold mining index during that period, and when the market began to
price in QE2 and US real rates fell further we bought again and enjoyed a
similar return.

We are now of the opinion that US real interest rates are still too low
in relation to the current gold price and therefore see the gold price
going still higher to $1500. Of course this works both ways, so if US
real rates begin rising there would likely be a serious correction in
gold. We are monitoring this situation closely and adjusting our
position (and that recommended to our subscribers) accordingly, but the
main purpose of this article is to draw investor’s attention to this
relationship and suggest that it form a pillar of your fundamental
analysis with respect to gold. This is not to say other relationships
such as the USD and gold are not to be noted, they should be, but in
conjunction with US real rates. By pulling all these relationships
together one can get a better picture of where the yellow metal is
headed and when it is going to move, which ultimately leads to more
profitable trading.