What drives the price of gold?
Craig Stanley, M.Sc.
Published 6/23/2009
Nothing seems to generate such passionate debate and confusion within the financial sector as the role of gold. Is it an inflationary hedge? Can it go up during deflation? Is it a safe haven or antithesis to the U.S. dollar? Will the impending IMF sales flood the market?
What is lost in the debate is what gold represents -- money. Gold is money that offers no yield (a negative yield after taking into account storage and insurance) and which is continually valued against fiat currencies that offer a yield.
Such a view was summed up best by Robert Barsky and Lawrence Summers in their article "Gibson's Paradox and the Gold Standard" (The Journal of Political Economy, Volume 6, Issue 3. June 1999. p. 528-550).
Nothing seems to generate such passionate debate and confusion within the financial sector as the role of gold.
Is it a safe haven or antithesis to the U.S. dollar?
Will the impending IMF sales flood the market?
What is lost in the debate is what gold represents -- money.
Gold is money that offers no yield (a negative yield after taking into account storage and insurance) and which is continually valued against fiat currencies that offer a yield.
â¬oeGold is a highly durable asset, and thus...it is the demand for the existing stock, as opposed to the new flow, that must be modeled.
In essence, real rates are calculated by subtracting inflation from benchmark interest rates.
(I use the University of Michiganâ¬(TM)s Survey of Consumers - one-year ahead inflation expectations.)
Such a real interest is referred to as ex ante.
Ex post real rates are calculated with a backward-looking inflation measure such as the year-over-year change in the Consumer Price Index for All Urban Consumers (CPI-U) as reported by the U.S. Bureau of Labor Statistics.
Decreasing real interest rates are positive for gold as it lowers the opportunity cost of holding the metal.
However, it is not a linear relationship.
Since President Nixon closed the gold window in 1971, there as not been one instance where U.S. three-month real rates fell below 0% that spot gold priced in U.S. dollars did not rise over the subsequent 12 months.
The last bull market in gold in the late 1970s and early 1980s corresponds to when three-month and 10-year real rates were negative on both an ex ante and ex post basis.
Gold prices spiked in late 2007/early 2008 as 10-year real rates went negative, subsequently falling during the summer and fall of 2008 as these rates climbed into positive territory.
Given that relative real rates affect the value of a currency, it is no surprise that movements in one have a positive correlation with movements in the other.
Since the last gold bull market, the correlation coefficient between month-end values of the U.S. Dollar Index and U.S. three-month and 10-year real rates have been around 0.57 and 0.69 respectively on both an ex ante and ex post basis.
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