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Should Gold Fear Higher Interest Rates

November 16, 2010 at 6:47 PM

If you ask 10 Wall Street pundits what drives the price of gold you will most likely get a variety of different answers. Some will say its fear or uncertainty, while others may claim it is international strife or the Indian wedding season. However, the truth is the main driver for the price of gold is the level of real interest rates.

The act of central bank money printing serves to temporarily drive down nominal interest rates while at the same time creating inflation. Therefore, subtracting rising rates of inflation from falling nominal interest rates, results in falling real rates of interest. Once real rates become negative, the liability of holding gold then converts to becoming an asset. The more real interest rates fall the greater the need on the part of investors to own gold.

This begs the question; should gold fear rising yields on Treasuries? The answer to that is, of course, only if the rise in nominal rates is also accompanied by rising real interest rates. For example, back in January of 1977, the dollar price of gold began an epic bull market, which ended just prior to February of 1980. Gold soared from $135 dollars per ounce to just under $860 per ounce during those three years. However, this move occurred while nominal rates were rapidly rising. The yield on the Ten Year Treasury soared from 7.2% in January of 1977 to 12.4% in February of 1980. But the increase in yield was just in nominal terms because the YOY change in the CPI jumped from 5.2% in January of 1977 to 14.2% in February of 1980. During that bull market in the price of gold, real interest rates went from a positive 2% to a negative 1.8%, despite that fact that nominal rates increased by 520 bps.

Today’s release from the BLS showed the October Producer Price Index increased by .4%, while the YOY increase in PPI jumped 4.3%. However, the Fed will most likely seize upon the month over month change in the core rate, which registered a negative .6%. Bernanke will overlook the largest YOY increase in PPI since May 2010 and instead worry about the deflation anticipated by core prices. That means he will find cover to print more money, thus—at least for now—keeping nominal rates from rapidly rising, while pushing inflation even higher. Real interest rates should fall and the price of gold will increase. In my opinion, there is no danger of having nominal rates outpacing the increase in the rate of inflation until the Fed unwinds its balance sheet a la Paul Volcker.

There will be a time when the Fed’s pursuit of inflation causes a crisis of confidence in our bond market and in our currency. A sudden and dramatic spike in nominal rates would send real interest rates rising and cause devastation in most markets including gold. However, the pullback in gold should be muted as compared to stocks, bonds and other commodities. Precisely because the Fed’s answer to that crisis would be to create more inflation.