Generally, the real interest rates are negatively correlated with the gold price, i.e. the rising interest rates adversely impact the yellow metal. Based on this adverse relationship between real interest rates and price of gold, Elfenbein built a model for the price of gold. According to it, whenever the dollar’s real short-term interest rate is below 2%, gold rallies, and whenever the real short-term rate is above 2%, the price of gold falls. Another rule of thumb is that gold moves eight times stronger than the difference between real interest rates and 2%. If the model is correct, the Fed’s future interest rates hike may be detrimental for the price of gold. However, there are many objections to the use of such a simple model, and generally to the adverse relationship between gold and real interest rates.
First, the nature of gold is much more complex than any other commodity, so searching for one ultimate factor determining its price, gold’s Holy Grail, will always result in failure. Since lots of factors affect its price, investors should beware of simple models and study history to test popular opinion.
Second, investors should be aware of the shortcomings of the correlation, which does not imply causation. It is equally possible to argue that causality runs in the other direction, i.e. the low gold price causes high real interest rates, or that both the gold price and real interest yields are driven simultaneously by some common external factors. Moreover, correlation often holds only during specific periods. High negative correlation (-0.82) between gold price and real interest rate founded by Erb and Harvey relates only to a period of 15years. With longer periods, the correlation falls to only -0.31.
Third, investors should analyze not only the changes in the real interest rates, but also their levels and trajectories. According to the quoted WGC’s report, high and rising real interest rates are much worse for the price of gold than rise from the low level. E.g., between October 2003 and October 2006 US real interest rates increased from -1 to 3%, while gold gained 60% during the period.
Fourth, investors have to remember that investment demand is only the (smaller) part of the whole demand for gold. Therefore, the adverse relationship between real interest rates and gold price is weakened by the jewelry demand, which increases, when the real interest rates rise and the gold price decreases. Similarly, industry demand can also be stimulated by the rise in the real interest rates, because such a rise is often accompanied by an improving economic situation.
This post was published at GoldSeek on 28 October 2014.