Gold price records are being broken
The gold price is at record levels when measured in US dollars. When measured in the mighty rand it is however well below its record levels of November 2008. Part of the strength of gold is the weakness of the US dollar.
The gold price in US dollar and rands; Daily data
Source: I-Net Bridge and Investec Private Client Securities
But gold lately is not exceptional
In recent months the gold price in US dollars has not behaved exceptionally: it has closely tracked commodity prices in general as the dollar weakened and the signs of a global economic recovery were read (See below).
Gold Price vs All Commodity Prices CRB Index (January 2009=100), Daily data
Source: I-Net Bridge and Investec Private Client Securities
Gold was very special a year ago
Gold was special when the credit crisis reached its apogee with the failure of Lehmans in September 2008, when it showed admirable defensive qualities and performed very much as a safe haven.
Gold vs Commodity prices 2008-2009 (Jan 2009=100), Daily data
Source: I-Net Bridge and Investec Private Client Securities
History tells us that gold, that barbarous relic (as Keynes described it with characteristic intellectual scorn), is more than just another commodity – it has always been a special store of value and is especially useful when the value of all other assets is threatened by war or financial crises, as has again been proved.
It took very special events to prove that gold is special
But as we show below, a sharp divergence between the trend in gold and other commodity prices, as occurred between September 2008 and March 2009, has been a unique occurrence over the past 30 years. It took the fear of a melt down of the banking and credit system to lead to a rush to gold and a liquidation of other commodities. Mere inflation fears, if that were the driver, would be common to precious and ordinary metals and minerals.
The gold price and the commodity price index (CRB) (Jan 2009=100), month-end data
Source: I-Net Bridge and Investec Private Client Securities
In ordinary times gold is very likely to behave in line with other metals and minerals
The state of the global economy and the balance between the real demand and supply of commodities will be a primary driver of real (after adjusting for inflation) commodity prices. However all asset prices, including especially hard assets in the form of gold and other metals and minerals that can easily be stored, are influenced by inflationary expectations, or more particularly by the prices of these commodities that are expected to prevail in the months and years ahead.
The cost of storing gold and metals is very important for speculators
These price expectations have to be compared with the cost of storing metals and minerals which in the case of precious metals largely comes in the form of financing costs. The cost of storing precious metals – unlike the cases of copper, coal, iron ore or even oil – is almost all financing costs, given the high value to size ratio that determines the cost of storage.
Financing costs rise with inflation too
Financing costs, that is interest rates, however also rise with more inflation expected, so increasing the costs of storage and discouraging the demand to hold commodities. Thus there has to be more to a rising price of gold and other commodity prices than inflationary expectations. The price of gold, to make it worth buying at current spot prices, has to be expected to rise faster than the costs of owning gold in the form of interest rates paid or foregone. Or in other words, the price in the future must be expected to rise faster than the costs of financing that is explicit in the ratio of the spot and future price of gold.
It is real interest rates, not inflationary expectations, that matter
Thus a key determinant of the current price of gold will be the relationship between inflationary expectations and interest rates – that is to say real interest rates. Real interest rates have fallen to very low levels in recent years and months. They are at half the levels prevailing in the early years of this century. These real rates are best measured explicitly in the yields on offer from government bonds that come with complete cover against inflation – the inflation linkers – known as TIPS in the US, for Treasury Inflation Protected Securities (See below).
The purchasing power of the fixed coupon payments to be made to the owner of a conventional bond will be fully diluted by inflation. Thus inflation exposed bonds have to offer compensation for expected inflation. Thus the yield gap between the lower yield on inflation linkers and the higher yields on long dated conventional bonds is explicitly the compensation on offer for bearing inflation risk.
The bond market is very complacent about inflation to come
This compensation currently on offer to the holder of a 30 year US Treasury Bond is but an extra 2% pa. Thus it may be said that investors in 30 year bonds are highly vulnerable to losses should inflation in the US average more than 2% pa over the next 30 years – that is to say there is very little inflation expected or little cover against higher inflation currently on offer in the conventional government bond market as we also show below. Thus there is very little inflation expected in the bond market where the fear of deflation rather than inflation is dominant. That the idea that the gold price is being driven by inflationary expectations that are absent in the bond market, does not seem at all consistent.
US government bond yields and inflation compensation, month-end data
Source: Federal Reserve Bank of St. Louis, I-Net Bridge and Investec Private Client Securities
A consistent explanation for the rising gold and other metal prices
It would be far more consistent to conclude that the gold price, as with other commodity prices, is being driven by a global recovery and low real interest rates, that is abnormally low costs of storing gold and other commodities. The evidence in the relationship between the gold price and real interest rates in the US, represented by the yield on 30 year US TIPS is very supportive of this explanation. The gold price rose consistently with the equally persistent decline in real interest rates after 2000. It may also be seen that the gold price fell away as real yields rose temporarily as deflation fears gripped the markets in 2008 and then recovered as real interest rates fell back again.
Real interest rates and the Gold price 2000-2009; Month end data
Source: Federal Reserve Bank of St. Louis, I-Net Bridge and Investec Private Client Securities
A better case for gold in portfolios
The case for gold cannot be based on inflationary expectations alone. If inflation rises unexpectedly, interest rates and so the financing costs in owning gold will also rise, taking the gloss off gold and other metals. Thus it will take lower real rates – or interest rates lagging well behind actual inflation – to drive the price of gold and other metal prices higher. Unexpectedly strong global growth especially when coupled with relatively low real interest rates will be especially helpful to the gold price as it will be to all commodity prices. Gold may not prove special in a world of rising commodity prices as real demand presses against real supplies but yet well worth holding.
The case for an insurance premium for gold
But the recent evidence that gold can still provide insurance against calamity is surely reason to keep more gold in portfolios than before as insurance against true calamity. The experience of the defensive quality of gold in 2008 when gold held up while the price of all other metals fell away could add to its long term attractions so adding a little special lustre compared to the more prosaic other metals. Global portfolios still contain but a sliver of gold – should portfolio managers decide that a little gold may provide useful insurance as it did in 2008 – the gold price could move permanently higher relative to other metals and minerals and maintain such a premium. Brian Kantor