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« Collection Call | Main |  Silver Wheaton Corporation Shares Up 100.00% since Buy Signal of the 9th August 2010 »

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

The 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.

As mentioned before, we are of the opinion that gold prices are heading to $1500, so if you would like to take full advantage of this then please visit our website to sign up to SK OptionTrader, our premium options trading service that costs just $99. We have closed 55 trades with 53 winners, and an average gain of 45% per trade including the two losing trades. Our model portfolio has an annualised return on investment of 84.35% without reinvestment of profits.

The charts in this article are plotted with the gold price in US dollars on the left axis and inverted US real interest rates on the right axis to show the negative relationship between the two. The US real rates data is taken from the US Treasury Real Yield Curve and are commonly referred to as "Real Constant Maturity Treasury" rates, or R-CMTs. Real yields on Treasury Inflation Protected Securities (TIPS) at "constant maturity" are interpolated by the U.S. Treasury from Treasury's daily real yield curve. These real market yields are calculated from composites of secondary market quotations obtained by the Federal Reserve Bank of New York. The real yield values are read from the real yield curve at fixed maturities, currently 5, 7, 10, 20, and 30 years. This method provides a real yield for a 10 year maturity, for example, even if no outstanding security has exactly 10 years remaining to maturity. Gold data is taken from the London Bullion Market Association.

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Reader Comments (4)

Yeah, for sure. The absolute value and direction of real rates are key drivers to the direction of gold prices and changes in trend. Well noted.

Just 3 quick observations:

1) Gold pays no interest and when real rates of return are negative, this isn't a drawback to owning it. That's implied in your second reason above, but I thought I'd note it, as it satisfies the academic types who get really hung up on the "doesn't earn interest" thing. (Kind of like today's bank account.)

As an aside, I understand from reliable sources that not only does gold pay no interest, you can't eat it either. Of course, in this respect, it isn't much different than a dollar bill, is it now?

2) Real rates are more profoundly negative that the charts show, because they use the fantasy CPI as the depreciation measure. Standard government-issue lies.

3) The Fed is either criminally insane or simply the tool of the "money power." in which case having negative real rates suits their overall purposes. (Gee boys and girls...It's a fresh new spin on serfdom!)

I think it's the latter, but either way, negative real rates are really indicative of a world turned upside down.

December 6, 2010 | Unregistered Commenterfallingman

Keeping things simple, and getting a point across clearly is no easy matter. I have not the time to edit, so please accept my apology if I fail.

First, we have to understand that while everything else is 'priced', as in 'ticketed', in the terms of money of one kind or another, money is 'priced' in interest rates. Interest rates are the 'cost' of money. That is simple enough.

Interest rates therefore reflect the 'supply and demand' of money. Here is where it becomes tricky, yet, when we 'see' it, it is quite simple. Perhaps best answered by the questions it poses.

Who, or what, controls the price of money, and why should it be controlled if we truly believe in that crap about 'free markets'?

Then we have, what 'money' are we talking about - real money, Gold, which has an 'inelastic' supply, (That means we cannot just create it at will, there must always be a cut off point, even though it may never be reached.
Or, Fiat which can be in tangible for - paper or cheap metal, or, and here is the beauty today - DIGITAL
where it only exists in cyberspace. There is absolutely no limit to that.

This is why today we can talk in sums that are way beyond anyone's imagination to conceive, though you may pretend you can. These sums could never exist in tangible form, and once you work it out, you will need no explanation.

But, can we not have 'digital' gold? I'm afraid so. And this is what begins to screw up simple economics. I firmly believe more gold is being traded today than exists in 'available' supply at least. Simply people are trading a commodity that could not be delivered if they all demanded delivery. Don't worry, they won't.

Actually, I hope all this is beginning to lead to confusion, because it is where I want to cut it short and get to the real point.

Trying to get to the answers we believe will bring enlightenment to our quest, as referred to in the article, at the best can only lead to the source of the tributary.

We are paddling (or piddling )about way down river.

Markets, gold, money, et al., are created by man (humans) they do not exist in the rest of the animal kingdom - anywhere. And in man (I mean you women to) it all originates from 'mind'. It has to be first thought into existence.

This is from where all these 'tributaries.

Therefore (back to 'the BIG picture' it is there we find the answers to the questions I posed at the beginning, along with the many I didn't.

Who 'fixes' the cost of money, and why. It has to be someone. If a machine works out the calculation, someone had to instruct the machine to do it.

Why does he/she do it - is it just capriciousness, because it is possible, or is there a reason behind it. I very much plumb for the latter. There is a VERY good reasoning behind everything, There is an objective that over rides everything.

No, any machinations by the 'source' (the top) are not to rip off the players ( As Shakespeare said, 'all the world's a stage....')in the same way that wars are not started to kill other people, that is never the real objective (source), its a 'tributary'. (The common man does not start wars, he tries to avoid them)

There is, therefore, a key unwavering objective to it all, and in another analogy - 'all roads lead to Rome'.

You should know what that objective is, you have been told, and shown, often enough. I am not going to provide a picture of Earth taken from space to support an argument that the world is round, to all those who are intent in believing it is flat.

December 7, 2010 | Unregistered CommenterRay Newton

May I ask that the 'web master' is instructed to provide an 'editing' feature, at least for a short time after posting. Often errors are not spotted until it appears posted. (as in the above).

There should always be a means of deleting, and inserting again, or merely correcting, by the writer. Otherwise it can detract from the whole purpose of the feature by the irritating discomfort of scratching heads. Or arousing comments that are time wasteful and unnecessary.

Thanks, in hope

December 7, 2010 | Unregistered CommenterRay Newton

Oh Mamma mia, just let me explain before anyone is mislead by my analogy -
'All roads lead to Rome' I am not inferring the Italian Mafia is behind it all. I have too many Italian friends and 'in law' relatives to risk that.

Neither am I inferring that it is all some 'sinister' conspiracy. 'Sinister', as is 'conspiracy', is a matter of point of view, upon which I cannot judge.

There are lots of things which are done in life which we personally may not like, but those doing them may feel they have the right motives for doing them. It is the philosophy of 'the end justifies the means', and added to that is the
simple, familiar, - 'you can't make an omelette without breaking eggs'

December 7, 2010 | Unregistered CommenterRay Newton

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