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

Tyler Durden's picture

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.

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americanspirit's picture

Interesting analysis but any strategy that depends on GLD or SLV is hostage to the criminal behavior of those who control those entities.

midtowng's picture

I remember reading articles about the relationship between gold price and real interest rates all the way back in 2003. The argument made sense then and it does now.

Jupiter's picture

This is completely wrong.


Have you ever heard of cointegration? 


This is a perfect example of two cointegrated series.


The dynamics underlying both gold and the 10 year appear to have some common factors.


BobPaulson's picture

I think he was just demonstrating correlation, not causation. The short time axis would be my concern. If they're correlated for 3 years, you need to know when they will stop being correlated. If they have been correlated for a century, show the whole chart.

midtowng's picture

I was reading articles and looking at charts about the POG/real interest rates relationship all the way back in 2003.

  It's not a perfect relationship, but it exists. it's fits in as well as the POG/Dollar relationship.

mcguire's picture

yeah, i agree.. there is no causality here, these things are just moving together.  they are taking turns with currency debasement, that is why i believe the correlation with gold/$ is perhaps more 'bumpy' than it used to be.  

h4rdware's picture

What is perhaps of more value, is predictions made >3 years ago by a few notable writers who pointed out that real interest rates were a primary driver for gold prices, with increasing correlation near and below zero. Antal Fekete was one. There were others.

However there are other serious implications if this holds true, so reading up on it is probably worthwhile.

Snidley Whipsnae's picture

What is also notable is that there were periods in the past ten years where interest rates were well above where they are now and gold continued to perform well in those years.

Interesting that China's appetite for gold was not mentioned. During this year China has increased their accumulation rate of gold by 500% over 2009....and, 2010 is not over yet. All of SE Asia/India physical gold importation is increasing at rapid rates.

Also interesting that central bank selling of gold has stopped.

BTW, I own no paper gold or silver.

h4rdware's picture

Agreed. I am quite sure negative real rates is not the only thing driving gold (no prizes for spotting the others), but neither is it to be ignored as it suggests acceleration, if anything, as real rates fall into a black hole and yield chasing becomes preservation.

Regardless, it's an interesting ride. Bring more popcorn.

midtowng's picture

Interest rates were far higher during the past decade, but so was the inflation rate. It's the real interest rates that matter.

 Of course the fact that China didn't even allow private ownership of gold in 2002, and is now the largest importer of it on Earth makes a difference too.

bull-market_3.0's picture

Agreed. Repeat Analysis from 1970-2010 please

scatterbrains's picture

anyone have a link for a live Irish vote count/announcment ?

CaptainAmerica's picture i buy silver or wait for it to go back to $19?

apberusdisvet's picture

Within 5 years, your total monthly paycheck will consist of a small pile of one oz silver coins.  Silver will only revert to $19 when Blythe becomes the gang bang of the New World Order cabinet.

goldsaver's picture

Just buy the fucking dips....

On a serious note. It depends on your horizon. If you are buying silver for short term trades, I recommend you go with PSLV and buy it when it returns to 28.50 or so and hold to 33. Turd would have much more accurate charts than I do.

If you are buying it as a safehaven for your wealth, just buy the dip. You will find daily manipulation either in the open or after 1:30EST of 50 cents or so. Buy it then, but understand that 50 cents and ounce on a projected short term (under 12 months) top of $50 is really meaningless.

Hephasteus's picture

You can't protect yourself from even more massive theft that is coming if you wait for the current theft to stop. If you don't buy silver now by the time it's 19 dollars again they'll have stolen what they need to go on and be back telling everyone what to do creating jobs.

QEsucks's picture

This is esoteric drivel. The real investment thesis on why gold is going to
200 will be discussed by Jon Nadler on Bloomberg this am. Heard it on the
radio. Still can't eat not the radio...I meant.

Arius's picture

 i think he is looking for a job...his latest article "Job hunting"...did not read it, but hey, i hope he finds a job...for the benefit of his employer i hope he gets out of forecasting PM...obviously,not his strongest suit...for too many years, has been always wrong (Gartman comes in a strong second)...c'est la vie..

watt's picture

What is the author's definition of "Real Interest Rates" and where is the data that enabled him to chart them ?

tony bonn's picture

this is an excellent article insofar as pointing out that gold is a is never good news to hear that people are pouring into gold even though gold is solid money....anyone rushing for gold is voting with his feet that the economy is not has ALWAYS played this role as a vote against bad economies and bad monetary policy....

the recent increases in margin requirements at the fake commodity exchanges is an implicit increase in interest is further evidence that the monetary order is in collapse....and along with it the economy....not on a cyclical basis but on a secular basis....the banksters are sucking the life blood from the economy....until these sociopathic kleptocrats are destroyed, they will keep destroying the economy....

Snidley Whipsnae's picture

This might add to the discussion....I certainly prefer gold to fiat when interest rates are near zero. There is no second party liability when holding physical gold.

"There is the possibility… that after the rate of interest has fallen to a certain level, liquidity preference is virtually absolute in the sense that almost everyone prefers cash to holding a debt at so low a rate of interest. In this event, the monetary authority would have lost effective control." John Maynard Keynes....'General Theory'

Keynes was discussing the theory of Zero Bound, ie; when interest rates become so low that individuals and businesses prefer to hold cash rather than invest it and expose themselves to counter party risk.

Hicks (another economist) speculated that monetary policy is felt in the real economy due to interest rates and at a certain very low rates of interest no further demand is stimulated for capital investment by lowering interest rates more.

All a long winded way of saying why not hold gold or other PMs/commodities when interest rates are low. Why hold fiat currencies that may be at risk of collapse? Why hold any paper with counter party risk when PMs are free of that CP risk?

Is the Fed going to raise interest rates soon? Does the Fed wish to abandon their great quest to reflate real estate and other asset classes (QEs)? Is the US government willing to impose austerity to cut the deficits?

I say no to all the above....certainly in the near term. Hey, maybe they will prove me wrong....won't be the first time. :)




SDRII's picture

read Feteke much more interesting

ddtuttle's picture

Great charts, pretty hard to argue with the pure empirical nature of the correlation(s). It is logical too. Gold pays no interest, in fact it has negative interest in the form of commissions and storage fees. So if the 10 year is paying out any significant interest above inflation, there is an incentive to swap some gold for treasuries. Likewise, if the real interest rates drop below zero, there is the idea that gold will do better than the inflation.

When real interest rates are negative, there is also something wrong with the economy. That implies an ongoing economic risk that gold prices in better than anything else. Depending how serious you believe that risk to be, will determine how much gold you'll want to have.

These two incentives explain the above chart, but there is something that can cause it to break down.

The reason gold is sound money is that it has a finite (very slowly growing) supply. That means as it becomes recognized as a alternative to deteriorating paper money, there will be supply and demand issue. SPecifically, as supply come under pressure, the price will rise beyond what is called for by real interest rates and economic risk. That will break the above relationship.