It is reasonably well established an understanding that there is an inverse relationship between gold and interest rate. Gold does not give yield and when interest rate increases, the opportunity cost of holding gold diminishes.
However, for the last 2 years, we have seen both US interest rate and gold prices increasing. The main reason was the weak US dollar.
We feel the primary determinant of gold prices is confidence in the dollar, which remains weak in spite of a rising rate scenario. That’s why gold is inching up.
Now, one of the headwinds gold may face in the near future is real yields moving from negative to positive. What are real yields? According to thebalance.com, “The real return is simply the return an investor receives after rate of inflation is taken into account. The maths is straightforward: if a bond returns 4% in a given year and the current rate of inflation is 2%, then real return is 2%.
Similarly, real yield is bond yield minus rate of inflation. Up until now because of depressed real interest rate, real yield was in the negative, but now with a rising interest rate, this year real yields have turned positive. The chart here shows large bearish divergence emerging between gold prices and real yields.
(Source: Topdown Charts)
Now, two scenarios unfold. One, the gap in the chart closes when real yield goes back below zero. The chances are very slim as Fed is on the path of rising interest rate and a transition is happening from Quantitative Easing to Quantitative Tapering. So, real yields are going to remain high.
Second, gold prices are correcting and we can see the gap decreasing. However, the correction in gold won’t be deep as a weak US dollar will give support to gold prices and the recent trade war between the US and China may give the boost gold needs to break out of its 2018 range of $ 50.
Gold is stuck between $ 1,360-1,313 at COMEX. Many people also see gold as a hedge and that is why with heightened geopolitical risk or bearish equity market or rising inflation, people flock to gold. Given the current scenario, we don’t see gold correcting too much and real yields going back negative. But something has to give for the mean reversion to happen. We feel that because of this divergence, gold may face headwinds and find difficult to scale high in the near term.
(Aasif Hirani is the Director of Tradebulls Group. He has 12 years of experience in the finance industry. Views expressed in this article are author’s own and do not represent those of ETMarkets.com. Readers are advised to consult their financial advisers before taking any position based on these observations)