We remain of the view that investment returns from gold will disappoint.

It is a widely held belief that gold is an inflation hedge. We challenged this view in a recent piece entitled Inflation protection is a noble aim, but not a reliable strategy (see What normalisation means for investors elsewhere on this website https://cernocapital.com/investment-view/).

The “Golden Constant,” was coined by Roy Jastram (1978) in which he observed that historically gold has been a poor hedge of inflation in the short run but a good hedge of inflation in the long run. The real price of gold maintained its purchasing power over long periods of time and gold’s long-run average real return is zero.  If we assume this long term relationship to be true, then plotting the gold price against CPI would reveal if current gold prices are above or below CPI. Historical data from 1875 shows that the gold price today is significantly above CPI, or put differently, to revert to the long term trend of zero real return, gold should continue its downward path and stands currently 70% above the price suggested by the CPI trend line.  Gold is often referred to as possessing insurance attributes but at today’s prices it is an expensive inflation hedge.

Another approach to understanding the price fluctuations of gold in shorter time periods is to consider real interest rates. Real rates in the US can be observed through inflation linked bonds (TIPS). The measured correlation between 10-year TIPS real yield and the real price of gold is -0.82 (from 1997 and the present day). When real rates rise, the gold price tends to fall and when real rates fall then gold rises. We might assume causality based on the opportunity cost of holding gold. This data goes back only 16 years to when TIPS were first introduced in 1997. We have created a synthetic real yield for the US with the help of Jan Groen and Menno Middeldorp from Bank of New York Fed/Liberty Street Economics for the synthetic series and examined the data from 1971 (when gold was no longer fixed) to reveal a similar result: the correlation between the real yield and the real price of gold was -0.64 which again is significant.

Chart: Historical gold price vs. US 10Y real yield (1971-2013)

Gold Graph

Source: Federal Reserve Bank of New York, Bloomberg, Cerno Capital

It is still necessary to make assumptions about real yields in order to forecast the price of gold. Over a three year horizon, if we assume normalisation of interest rates and that inflation will be relatively stable in that time period, this would suggest higher real rates. Assuming stable correlations, the implication is for a lower price of gold.

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