Thursday, August 22, 2013

Gold and Real Rates: "What Determines the Return on Gold?"

I have become very reluctant to link to most economist's blogs. More and more it seems economists are nothing more than wannabe politicians who don't have the guts to run for office and who, instead, gussy themselves up in a bit of math before finding an echo chamber to preach their politics to.
Life's too short.

However, here's a guest post by a student who seems not to have picked up the playground-squabble tone that so much econ writing exhibits these days.

Plus, for me anyway, it just oozes confirmation bias.
Gold $1372.40, 10 year yield 2.907 up 5.2 bips.

From Not Quite Noahpinion:
What Determines the Return on Gold? 
Gold glitters, but from an investment perspective it does little else. It is backed by neither cash flows (like stocks are) nor a value at maturity (like bonds are). It's just a metal that, historically, has always been highly valued: a value that exists beyond its role in jewelry or in industry.

So what gives? Broadly speaking, when people make a bull case for gold, they tend to talk about two catalysts. First, they argue that because central banks are engaging in expansionary monetary policy, this will lead to massive levels of inflation that will drive gold prices higher. Second, they argue that gold is valuable because it acts like a panic button and serves as insurance against crisis. These in fact, were the primary motivators behind Paulson's famous bet on gold. In this post, I hope to show that the theory underlying (1) is flat out wrong, and that the logic behind (2) does not correspond to the actual challenging facing the world right now.

So let's first talk about inflation. The argument goes that since gold is a precious metal with "intrinsic" value, its price will rapidly appreciate in an environment of rapid inflation. Unlike a fiat currency, gold cannot be "debased" and therefore even if the Fed prints too many dollars, the gold coins will still hold onto their real value. In a world in which wheelbarrows of paper money buy only loaves of bread, gold will still make sure you can still eat. This value across all levels of inflation means that gold prices spike if inflation rises, and thus holding gold can hedge that risk.

Most arguments against this thesis have come down to (correctly) observing that central banks have not caused high levels of inflation. Given high levels of slack in developed economies, central banks are also unlikely to cause high levels of inflation. But this concedes too much. In truth, inflation hardly drives gold prices at all.

When people think of high inflation, they naturally gravitate towards the late 70's, early 80's -- a time of rapid growth in gold prices. But this was a special time for many reasons, not least of which was the United States decision to suspend dollar convertibility. But ever since those inflationary years, although gold has had its ups and downs, its price has actually been relatively uncorrelated with levels of inflation. In fact, if you look at the scatter plot below, you'll notice that the positive relationship between gold and inflation is almost entirely driven by three data points: 1974, 1979, and 1980. Once you drop those three years worth of observations, you go from the upward sloping dotted line to the solid downward sloping one. This suggests that inflation is actually a horrible predictor of where gold is going to go, and that we should look elsewhere for a guide.
So what is this other guide? Real rates. In fact, yearly return on gold is almost entirely determined by a the 10 year treasury yield minus the year over year inflation rate. To see this, consider the following scatter plot. Unlike the gold-inflation relationship, the real interest relationship is not driven by just a few data points. Both the 1970's and 2011 gold price spikes are explained by this relationship. Moreover, the relationship between the variables seems consistent through all levels of the real interest rate. This is evident from the fact that the non-parametric loess fit (the red line) and the linear fit are roughly consistent with each other.

This observation makes the most sense in the context of a Hotelling model -- a note that Paul Krugman has previously made. For a full explanation of the mechanics of the Hotelling model, I suggest you read Krugman's post. But the intuition for the model is that a higher real interest rate lowers demand for gold since the opportunity cost of holding it increases....MORE
HT: Abnormal Returns


Aug. 19
As the 10-Year Yield Sets Another Cycle High A Bit of Nervousness on Gold
The yield on the 10 year bond traded at 2.8660% this morning while gold has been inching up. This can't last and my bet is gold buckles before the yield does... 
The Mid-April Reversal of the Treasury-yield/Gold-price Correlation
Inflation and Real Rates or What's a Fed Chairman to Do?
Real Interest Rates and Gold
So Why is Gold Down? Look To the Real Interest Rate
Barron's on Gold and Real Interest Rates

Confirmation bias, know what I'm sayin'?