The price of gold hit a new all-time high in 2020. Fears of rising inflation and the Fed’s opening of USD swap lines with the world’s major central banks have resulted in a steady trend on the downside of the greenback.
Fast forward ten months, and things have changed. As inflation fears persist, the price of gold has corrected by several hundred dollars from the all-time high in 2020.
Traders wishing to buy and hold gold in their portfolio should be aware of one of the tightest correlations in financial markets – that between the price of gold and real US 10-year rates. It is the correlation between these two assets that puts pressure on the price of gold. In other words, despite some rebounds here and there, unless the correlation breaks, the price of gold will remain under pressure.
Looking back over the past decade, the correlation has held up remarkably. So why should it break now? What if that doesn’t happen?
Gold, Debt and Yields – A Trio to Consider When Investing
The chart above reflects the inverse correlation between gold and the US 10-year yield. In other words, when yields go up, gold goes down – and vice versa. As the returns are reversed, the chart shows that the two financial assets are closely correlated.
Yields represent the return expected by investors when they buy a bond. The higher the yield, the better, but also the riskier the bond. In general, high yield bonds are junk bonds, while the so-called risk-free rate is the yield on 10-year US bonds. Therefore, when the returns rise on the risk-free instrument, the world is listening.
The pandemic has triggered massive monetary and fiscal stimulus in the United States. At least in the fiscal area, the easing exceeds anything seen in other parts of the world. Yet with it comes an increase in debt.
America is in deficit, and the money it spends is borrowed. Literally, this means that it is issuing bonds to finance its deficit. Or, it issues new debt to finance the deficit and new fiscal easing measures.
However, the lower the yields, the less attractive bonds are. America must therefore allow yields on risk-free assets to rise, in order to make bonds attractive to investors and to find buyers for its debt.
Based on the correlation presented at the beginning of this article, this is enough to put enormous pressure on the price of gold. With the rise in the price of gold comes a fall in yields. If the Fed lets yields rise a little further (and it may not have a choice), the price of gold will have a hard time rebounding.