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Three Drivers of Gold, Second Look

Commodities / Gold and Silver 2018 May 26, 2018 - 07:28 PM GMT

By: Arkadiusz_Sieron

Commodities

Let’s take a second look at the drivers of gold. We have already stated that the three most important factors are: the real interest rates, the U.S. dollar, and the risk aversion. Fair enough. But we have presented just the first approximation. We need to dig deeper. Why?

First, all these variables are connected together. Many analysts and investors who listen to them often make a mistake, assuming that the forces which push one driver have no effect on the other inputs into the value of gold. This is a dangerous delusion, which may expose investors to heavy losses.


For example, low confidence in the economy should also increase the real interest rates and weaken the currency (however, the U.S. dollar is also seen by investors as a global safe haven, so during market turmoil gold can actually rise in tandem with the greenback, as at the turn of 2008 and 2009).

And when the U.S. real interest rates fall, it should weaken the greenback relative to other currencies, including gold, in line with the interest rates parity. Very low real interest rates may also increase uncertainty (as investors are afraid of secular stagnation then, or they worry that rates will have to rebound one day – indeed, ZIRP and NIRP diminished trust in the economic prospects, at least initially).

Last but not least, when the value of the U.S. dollar fluctuates wildly, it can increase the risk aversion. The rise in the uncertainty should boost the real interest rates, as they can be perceived as the sum of the risk-free rate and the risk premium.

Second, we have analyzed the direct drivers of the gold prices. However, we haven’t yet discussed the indirect factors, or drivers of the drivers. We mean here that explaining the move in gold prices expressed in the U.S. dollar by fluctuations in the U.S. dollar actually gives little information to investors. Investors deserve a better understanding of what the underlying drivers are.

For example, the real interest rates are nominal interest rates adjusted for inflation. And the nominal interest rates have two components: the risk-free rate and the risk premium. The risk-free rate is what investors can make on a long-term, default-free investment. The yield of 10-year U.S. Treasuries is usually used as such rate, while the risk premium is taken from the spreads between the U.S. government bonds and risky securities. However, the risk aversion, or the perception of uncertainty is something more and it probably cannot be measured accurately, as it has some subjective components.

The case of the U.S. dollar is more complicated, as we should take many factors into account, such as: the level of interest rates, the level of risk aversion (the greenback is also a safe-haven currency), the U.S. monetary, fiscal and trade policies, or inflation.

Inflation – let’s focus on that for a while, as gold is widely seen as an inflation hedge. How does it affect the price of the yellow metal? Well, the higher inflation, the lower real interest rates are (and the vice versa). And when American prices go up, the purchasing power of the U.S. dollar erodes. Finally, the surge in inflation increases uncertainty. Therefore, the metal shines during periods of high and accelerating inflation, as inflation affects the gold prices via the interest rate channel (it lowers real yields), the currency channel (it weakens the greenback), and the risk aversion (it elevates the general uncertainty in the economy). Hence, we haven’t distinguished inflation as the driver of the gold prices, but it influences them indirectly, affecting all the three main direct factors.

To sum up, investors shouldn’t make the frequent analysts’ mistake and focus only on one piece of gold’s value puzzle. When we model the price of gold, we simplify reasoning and hold many factors constant. But in the real world, there are no constants. We don’t live in physical laboratory, but in the complex economies, where everything is interconnected. All gold drivers are connected together and almost any macroeconomic change – like a financial crisis, a tax reform, or rising yields – affects all of them, making the fundamental analysis very challenging. Hence, the more sophisticated version of Golden Triad of Gold’s Drivers should look like the diagram below.

Diagram 1: A More Sophisticated Version of the Golden Triad of Gold’s Drivers.

sp-pic-3.png

Let’s take the issue of rising Treasury yields. If this increase is real-growth driven, it is a net negative for the gold prices. But if we see an inflation-driven increase in interest rates, the yellow metal should gain. Which narrative is true? We believe that the former – inflation is on the rise, but not dramatically – and the real interest rates are also climbing. Nevertheless, this example clearly shows that investors should always adopt a broad view and work through the net effect.

If you enjoyed the above analysis and would you like to know more about the gold ETFs and their impact on gold price, we invite you to read the April Market Overview report. If you're interested in the detailed price analysis and price projections with targets, we invite you to sign up for our Gold & Silver Trading Alerts . If you're not ready to subscribe at this time, we invite you to sign up for our gold newsletter and stay up-to-date with our latest free articles. It's free and you can unsubscribe anytime.

Arkadiusz Sieron
Sunshine Profits‘ Market Overview Editor

Disclaimer

All essays, research and information found above represent analyses and opinions of Przemyslaw Radomski, CFA and Sunshine Profits' associates only. As such, it may prove wrong and be a subject to change without notice. Opinions and analyses were based on data available to authors of respective essays at the time of writing. Although the information provided above is based on careful research and sources that are believed to be accurate, Przemyslaw Radomski, CFA and his associates do not guarantee the accuracy or thoroughness of the data or information reported. The opinions published above are neither an offer nor a recommendation to purchase or sell any securities. Mr. Radomski is not a Registered Securities Advisor. By reading Przemyslaw Radomski's, CFA reports you fully agree that he will not be held responsible or liable for any decisions you make regarding any information provided in these reports. Investing, trading and speculation in any financial markets may involve high risk of loss. Przemyslaw Radomski, CFA, Sunshine Profits' employees and affiliates as well as members of their families may have a short or long position in any securities, including those mentioned in any of the reports or essays, and may make additional purchases and/or sales of those securities without notice.

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