Financial pundits like to say the price of gold is affected by the dollar, inflation, nominal interest rates, and geopolitical events. Every time you open the paper or read an article online, you will see some headline stating "Gold up as investors seek hedge for dollar decline" or "Gold down as strong dollar reduces demand for safe have." Statements like these are so far off that I simply cannot stand to read them anymore. Why? Because they perpetuate the myth that gold is somehow tied to these variables which is not accurate to anyone who has studied the topic. The only real variable which determines the price of gold is the level of real interest rates. The real interest rate is the difference between the nominal interest rate and inflation rate. This is an very important indicator because it shows investors the benefits and risks of holding dollars. When real interest rates are positive, it means that holders of dollars make money adjusted for inflation. However, if real interest rates are negative, holders of US dollars lose money, which gives them a strong incentive to diversify their assets.
This brings us to gold and real interest rates. Gold is and has always been a form of money throughout human history, even though it is not currently recognised as such by national governments. When we have negative real interest rates, it makes sense for holders of dollars to transfer their wealth to another form of money, and gold is the preferred go to asset. We know that money often goes to where it is best treated and with negative real interest rates, gold makes a lot more sense than dollars which are guaranteed to lose money adjusted for inflation.
Let's take a look back in history and see the effect of real interest rates on the gold price. If you look at the chart below, you will see that during the 1970-1980 gold bull market, real interest rates were almost always negative as the Fed tried to boost the economy through cheap money (very similar to our present time). This policy reduced the attractiveness of holding dollars. It was not until the arrival of Paul Volcker and a return to positive interest rates that caused the gold price to decline. When the dollar has value (positive interest rates), there is no reason for holders of dollars to own gold. This gold bear market continued from 1980-2000 as the dollar maintained value, discouraging the need for alternatives. However, in response to the dot-com bubble, the Federal Reserve once again reduced interest rates, resulting in negative real interest rates to holder of dollars. Naturally, dollar holders turned to the alternate form of money--gold--and thus began the current bull market in gold. Despite a few brief spikes, negative real interest rates have been the norm during the past 10 years and remain so today. This dynamic ensures a strong gold price for the foreseeable future.
click chart below for larger image
So when the gold bubble prognosticators try to scare you by saying gold is going to down when the Fed starts to raise interest rates, don't pay them any notice. The only thing that matters for gold is the real interest rate. If we saw the return of Paul Volcker as Fed Chairman, I would be the first one to start selling my gold, but until that happens, we are left with Zimbabwe Ben who is not likely to raise nominal interest rates until Q1 of 2012 (according to the Fed Fund futures). Owners of gold have a strong ally in Bernanke who is determined to prevent positive real interest rates at all costs to protect bankrupt financial institutions. Only a change to positive real interest rates can derail the gold bull market. Until then enjoy!
Related Articles:
Will Gold Play Role In New Monetary Order?
Gold will remain solid.
ReplyDelete