- Weak economic growth will prevent the Federal Reserve from raising interest rates.
- Leading indicators of inflation have moderated their decline, providing upside to inflation expectations.
- The Federal Reserve is likely to expand their balance sheet after pausing "NotQE" at the end of Q2.
- The combination of weak economic growth and less bad inflationary expectations is a recipe for lower real rates, the ultimate fuel for a rally in gold.
- In the context of a balanced portfolio, gold has been an overweight position at EPB Macro Research as we start 2020.
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Gold has powered into 2020, rising nearly 6% in the past month.
Gold serves many purposes as a part of a balanced portfolio. Gold acts as a diversifier, not always correlated to the stock market nor nominal interest rates. The yellow metal can rise in both an inflationary scenario and a deflationary environment, and portfolios that maintain some permanent allocation to gold as an insurance policy tend to benefit from lower volatility.
The amount of gold in your portfolio is largely influenced by personal preference and your existing investment strategy. Still, any investor who is running a portfolio that intends to resemble some balance of risk likely has a spot for gold.
When discussing the performance of an asset, I like to deal with "overweight" and "underweight" allocations of risk relative to your baseline portfolio. In other words, if you have a standard 5% allocation to gold in your portfolio, adding risk may look like an 8% allocation or a 10% allocation. For some, an 8% allocation may be underweight. This note is not to debate the proper weighting of gold in a portfolio but rather to outline a thesis that suggests the upcoming environment will likely continue to be favorable for gold.
Source: Bloomberg, EPB Macro Research
The primary driver of gold is the rate of change or the change in the direction of real interest rates.
When Dealing With Gold, Look At Real Rates
Real interest rates are the primary factor in moving the price of gold. The real interest rate is the current interest rate minus inflation expectations. Many analysts calculate the real interest rate by taking the 10-year yield and subtracting the most recent CPI reading. I prefer to use Treasury Inflation-Protected Securities as my proxy for real rates or taking the nominal interest rate and subtracting breakeven inflation expectations.
For this note, when referencing real interest rates, I will be using 10-year real rates.
Real interest rates influence the price of gold because the real interest rate represents the opportunity cost of holding gold. By holding gold for 10-years, you give up the opportunity of locking-in today's 10-year real rate. If real interest rates move lower, you give up less, and therefore, gold is a more attractive alternative store of wealth.
The chart below shows the price of gold (yellow) and real interest rates (red). Real interest rates are inverted in the chart, as these factors have an inverse correlation.
Gold Vs. Real Interest Rates:
Many charts circulate that show the amount of negative-yielding debt is the main driver of gold or the strength of the dollar. Ultimately, the driver becomes real interest rates. More negative-yielding debt likely means lower interest rates and likely lower real interest rates. The strength of the dollar has an inverse correlation with gold on average, but this relationship does not hold to nearly the same degree as real interest rates. Often, a rising dollar is disinflationary. This feeds through to lower inflation expectations and, thus, higher real interest rates and lower gold prices. This leads many to believe that a rising dollar means falling gold, but it has to square through real interest rates. If the dollar is rising, but real rates are falling, gold will likely trade with the latter.
To have the highest probability of getting the direction of gold correct, we must have a thesis behind the direction of real interest rates.
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