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We cannot value gold. It does not generate any cash flows, which we could discount. But it doesn’t mean that the price of gold changes randomly. Market sentiment is powerful in the precious metals market – but the same applies to other markets (after all, humans are emotional creatures). However, it does not operate in a void. Actually, there are some important fundamental drivers at work. Just like in the cosmos. It seems to be empty space – but gravity works there. Similarly, the precious metal market seems to be very emotional and without any logic, but when you look closely, you will discover important forces in action. What are they?

Our research has shown that the most important elements in the gold’s puzzle are: the real interest rates, the U.S. dollar, and the risk aversion (although its less seen in the data). It’s the Golden Triad of Gold’s Drivers (see the diagram below). Let’s analyze them.

Diagram 1: Golden Triad of Gold’s Drivers.

Real Interest Rates And Gold Prices

Why do the real interest rates matter for gold? Well, resources are scarce. Everything comes with a cost. Holding the yellow metal in a portfolio is not an exception here. Some costs are clear: storage and insurance of gold. But these expenses are not the main costs. The most important are the opportunity costs for foregone interests. Instead of holding gold, investors could be lending it (or the cash spent) out. The higher the real interest rates, the larger are the opportunity costs of investing in gold, so investors are less willing to hold a lot of the shiny metal (think about the 1980s and the 1990s, when Volcker increased nominal interest rates, pushing the real rates higher). And the lower real interest rates, the smaller are the opportunity costs, so people are more eager to hold more gold. In particular, the negative real interest rates are gold’s real friends (the 1970s or the post-Lehman era are the best examples).

The key is that if on aggregate people want to increase their gold allocation, the only way for that is when the price of gold rises relative to other investment assets. This is because if all people desire more gold, there is nobody there to buy from, so its relative price has to increase to force some bullion holders to sell it. Gold is money, so when all try to hold more of it, its price has to rise.

And what do the data say? As one can see in the chart below, the long-term correlation (since 2003) between the real interest rates and the gold prices is -0.87.

Chart 1: The price of gold (yellow line, left axis, P.M. London Fix) and the U.S. real interest rates (red line, right axis, yields on 10-year Treasury Inflation-Indexed Security) from 2003 to 2018 (weekly averages).

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