Daily Archives: June 10, 2022

L. Glenn Lawrence, writing from Ronda, Spain

With consumer price inflation raging globally, I thought it would be a good time to revisit an analysis I drafted several years ago. We addressed the effect of “real” bond yields on gold prices and developed a simple econometric model as an objective indicator of a fundamental driver of the direction of gold prices.

This year we improved the model.

For those not familiar with the concept of a “real” yield, here’s a simple definition: the real yield is the effective yield of United States Treasury bonds when adjusted for consumer price inflation. It’s an essential fundamental driver of gold prices.

When bond yields are not high enough to provide a reasonable return in excess of the consumer inflation rate, investors and traders tend to seek the safe haven of gold. Conversely, when bond yields are high enough to offer a generous return above the inflation rate, investors and traders leave the safe haven of gold and seek a conventional return on capital in assets like government bonds.

Gold is a commodity (or form of money if you prefer) that effectively has a negative return. Gold doesn’t pay interest or dividends. Gold owners cannot earn a rate of return on the capital used to purchase gold. And in larger commercial quantities, gold owners have to pay a fee to store their holdings. The storage cost of gold effectively becomes a negative return. Historically, when investors are afraid inflation will erode the value of their investments or fiat currency, they willingly pay the penalty of the negative return because they believe gold will protect their wealth.

Developing technical and econometric indicators based on the real yield is the key to monitoring whether investors will seek the safe haven of gold or will pursue interest-bearing investments. Let’s look at some examples of the real yield.

For ease of use and access to data and consistency of bond issuance, we use data from the U.S. Federal Reserve for the yield on constant maturity 10-year Treasury securities and the annual rate of the median consumer price index.

In a previous commentary, we analyzed the real yield threshold where investors and traders were incentivized to own gold rather than Treasury securities. We found that a range of between 2% and 3% (i.e., yield on Treasury securities of 2% to 3% greater than the annual rate of consumer price inflation) was historically the most effective pivot point. We chose a threshold value of 2.5% for the analysis.

We have since tightened that threshold to 2%. Historically, the real yield is typically 2% or less most when gold prices are rising. Gold prices are generally weak when the real yield is above that threshold. But there are exceptions to this rule, and we have added to our arsenal of econometric indicators to improve our fundamental modeling.

It’s not just whether the real yield is above or below 2% that matters—the prevailing trend of the real yield also matters. It can be argued that, in the modern financial world of “risk-on / risk-off,” the trend of the real yield is even more important than its absolute value.

An important case in point is 2013. The real yield was below the pivot threshold of 2% for the entire year yet gold prices were in a downtrend for most of the year. But what also occurred in 2013 was that yields on U.S. Treasury securities were rising and outpacing the rate of inflation, driving a solid uptrend in the real yield.

It didn’t matter as much whether the real yield was below or above 2%; what mattered was that the real yield was improving rapidly. The uptrend in the real yield led to optimism on the part of investors and spurred them to sell gold and buy U.S. Treasuries.

Let’s look at the example of 2013 and then compare it to today’s market.

Figure 1 presents a chart of the real yield in 2013 (blue line). Notice that the real yield was generally moving higher for most of the year. Remember, gold is not an attractive investment when the real yield is trending higher.

We have developed an indicator to track the trend of the real yield, which is the green line on the chart in Figure 1. Notice that our trend indicator headed higher for most of the year – this is a strong signal not to buy gold during that period.

Figure 1

 

In the next chart in Figure 2, we add the price of gold to the first chart, represented by the price of GLD, a leading gold exchange-traded fund. Notice that GLD was generally falling in price while our SX Trend Indicator was rising (indicating that you should avoid owning gold). GLD fell over 20% during that period.

Figure 2

Next, let’s look at the past year’s real yield and our SX Real Yield Trend indicator.

This is the opposite of 2013 until the last few weeks. The downward trend in the real yield, which has been not just below the critical 2% threshold but negative in 2022, is precisely the kind of inflationary environment where investors tend to seek the safety of gold. The real yield is both far below the 2% threshold, and the trend has been firmly lower (meaning that U.S. Treasury security yields are performing relatively poorly compared to the surging rate of inflation).

How did gold perform in this environment? Gold rallied in the fourth quarter of 2021 and the first two months of this year as the inflation rate skyrocketed. Its strong rally was capped by a rapid move higher as an initial crisis reaction to Russia’s invasion of Ukraine. But what about the last few weeks? If inflation continues to be a problem, why has gold been going down?

The answer is that the trend of the real yield has reversed. The annual consumer inflation rate has declined slightly since January, while the yield of U.S. 10-year Treasuries has climbed substantially.

On the following chart in Figure 3, you can see that between early September 2021 and early March 2022 our SX Real Yield Trend indicator was heading lower, which is a buy signal for gold. And indeed, GLD moved higher. But beginning in the middle of March, our SX Real Yield Trend indicator started trending high, which is a sell signal for gold, and indeed, GLD has started moving lower.

Figure 3

With this new development of the SX Real Yield Trend indicator, our econometric modeling includes both the 2% threshold for the real yield and, most notably, the trend of the real yield. You want to be a buyer of gold when three things occur:

Our SX trend models are signaling that gold is in an uptrend.
When the real yield is below 2%.
When the trend of the real yield is lower.

But when our SX Real Yield Trend indicator is in an uptrend, be careful owning gold because gold prices face strong headwinds.

We’re scheduled to roll out our SX Wealth Precious Metals advisory service later this year. Our service will include a combination of econometric and technical price models.  

Precious metals can be highly volatile. And volatility is one major reason why we introduced our SX Wealth’s VolatilityEdge™ technology,  powering and informing our first-to-market trading signals, trading indicators, and advanced trading analysis for crypto.

For more information, visit Sovereign X’s SX Wealth channel.