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« The Gold Report: ‘John Mauldin's Prescription for Avoiding Economic Catastrophe’ | Main | SK Option Trader Passes 500% Return Since Inception »
Friday
Sep212012

An In-Depth Analysis Of Trading Gold Relative To US Real Interest Rates

At the start of 2012 we publicly proposed two pair trades for 2012.

Nine months later and with huge changes in the market having occurred, we are revisiting our recommendation for the GLD/TIP compression pair trade, which has performed well over this period.

Our argument for this trade at the time was as follows:

“Historically US real interest rates have an inverse relationship with gold prices, a relationship which we have written about frequently. The basic premise is that when monetary policy becomes more accommodative, US real interest rates decline and gold prices rise due to the ease in monetary policy.”

Our explanation for the inverse relationship between gold and U.S. real rates is as follows:

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 sends 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.

For further reading on this topic please see our previous articles on the subject:

The Key Relationship Between U.S. Real Rates and Gold Prices

Decline in U.S. Real Rates to Send Gold Past 1800

What Future U.S. Monetary Policy Means for Gold

These are all useful in reinforcing the dynamics of the relationship between real rates and gold.

Back in January when we originally proposed the GLD/TIP trade, the chart looked like this:

Note: TIP is the plot of treasury prices. Prices move inversely to interest rates, TIP higher = real rates lower. Therefore although it appears that real rates are rising, TIP is a price, not an interest rate.

At that time, real rates implied a GLD price of around $180 (Gold at $1850). Before the end of February our convergence hypothesis was validated as GLD rallied to around $172 with TIPs relatively unchanged from their level in early January.

In March the gap widened considerably with gold declining and TIPs rising.

At the time we had no open gold positions as we were well aware of the downside potential. We haven’t been wrong about gold’s direction all year.

In July the two moved furthest apart with TIP stubbornly high at 119.5 (real rates low) and GLD relatively very low at around 150.


Incidentally, at this point we opened two long gold positions that have since turned nice profits. These trades can be viewed here and here.

Had we of actioned this pair trade in January, we would have used leverage to amplify our return. Our justification being this was a very safe position; as our further analysis proves.

At the time we recommended the trade, it was with a longer term focus, ie 6-12 months.

The GLD/TIP pair trades performance is plotted below. 5x leverage is the orange line.

Had we placed this trade in January with 5x leverage, we would have earned 44% in around 50 days. At this point we would have closed the trade with a good gain pocketed. So although the negative returns from May through August look bad, we would not have held the trade this long. Our preference is to take profits relatively early on. As the saying goes, no one ever lost money selling at a profit. And the whole point of the trade was to profit off TIP/GLD convergence - which is exactly what happened in February, why would we have held the trade beyond that.

To analyse this performance, we must look at it on a risk adjusted basis. What we mean by risk adjusted is this:

Image trader 1 makes 100% on a trade, and trader 2 makes 15% on a different trade. Although on the face of it trader 1 is the better performer risk is not factored in when analysing their return.

If trader 1 made 100% on a coin toss you wouldn’t applaud his performance – he got lucky and risked a lot. His coin flip “trade” was a poor decision in which chance did the work.

If trader 2 returned 15% on an arbitrage (risk-less) trade, you would be very impressed because the return he generated far outweighed the risk he took.

This is at the core of what we do. We look for high return trades with the lowest possible risk. If balance is in our favour, we place the trade. You would assume that with our rate of success we are very good at picking great risk vs return imbalances. We look to take chance right out of the equation.

The Sharpe ratio is a good measure of risk adjusted returns. Anything greater than 1 is considered good, and implies the return achieved outweighed the risk taken on.

The Sharpe ratio of this GLD/TIP pair trade is 1.44, which is very good, implying we recommended a trade with a very good risk return balance.

If one had of timed the trade perfectly, buying in at the biggest point of divergence in July, the leveraged return would be 58.6% in around 100 days.

With gold’s recent upswing on the back of QE3, the gap between real rates and gold is closing. With gold set to rally even further thanks to QE3 we believe the gap will close further if not desist altogether. If the gap is to close, the implied gold price is at least $1900 (GLD @ 185). Something we do believe will occur eventually, but timing remains uncertain. The leveraged return if this occurs, since January, would be 70.14%.

If the gap does close completely the outright profit on this trade since January would be 14.02% or with leverage, 70.14%.

If one had of timed the trade perfectly, buying in at the biggest point of divergence in July, the leveraged return would be 58.6% in around 100 days.

Looking forward we are very excited about the current prospects in the commodities and precious metals markets. With a fresh round of indefinite money printing just announced in the US we think gold is set to rally strongly soon. Gold may well challenge its all-time highs achieved last year and we are so confident that if the next $200 move in 2012 isn’t up, we will refund the cost of the  subscription to those who sign-up during this limited offer period. This offer is for a very limited time only so get on board now!

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