The basic fundamentals behind this inverse relationship are that when US monetary policy is looser, real rates fall and therefore investors buy gold for a number of reasons. We have covered this relationship in previously commentaries, but for new readers will we run through the dynamics at play here. Firstly, lower real rates could imply higher inflationary expectations in the future therefore gold is bought as a hedge against this possible inflation. Secondly, lower real returns in Treasuries drives investors into risk assets in search of a higher return. This also sends gold higher but it also sends most commodities, risk currencies and equities higher too. Thirdly, lower real returns on Treasuries reduce demand of US dollars, causing the dollar to fall and therefore the gold price to rise in US dollars. Finally, looser monetary policy implies that the economic situation is not as rosy as many would like to believe, so if the Federal Reserve acts by loosening monetary policy and driving down real interest rates then that sends a message that the economy is in a bad place therefore investors buy gold as a safe haven asset. There are probably many more reasons for this relationship, but we have just tried to cover the main ones.
Many gold investors tend to focus on the relationship between the US dollar and gold, citing that a lower dollar leads to higher gold prices in US dollars. Whilst this is an important dynamic of gold prices, the relationship gold has with US real interest rates is perhaps more important and more reliable for trading and investment purposes. For the first few years of this gold bull market, it was sufficient simply to acknowledge the USD down, therefore gold up dynamic, but in recent years things have changed. Over the past couple of years gold has rallied when the greenback has been making gains, as well as when it was weakening, therefore investors must now take note of the inverse relationship between US real interest rates and gold, which has been observed more consistently.
Whilst this inverse relationship is not perfect, it does have a distinct theoretical advantage over simply watching the USD versus gold relationship as sometimes both US dollars and gold can be in demand as safe haven assets. For example if there were to be a crisis, such as the recent sovereign debt issues in Europe, money would flow into gold in search of a safe haven, but also into dollars to escape the European issues. This creates what we dubbed "The Eurozone Crisis Premium" in the gold price. Investors would sell European bonds driving their yields higher, and buy US bonds driving their yields lower. Gold would be rising and the US dollar would be rising, negating their usually negative correlation. However US rates would be falling as investors bought treasuries as a safe haven and therefore the inverse relationship between gold and real US treasury rates is more likely to hold. That being said, we do of course closely monitor the currency markets as well as the interest rate markets, since both have major impacts on the price of gold.
The theoretical aspects of this relationship may all be well and good, but what really matters to investors and traders such as us is how these theories can be applied in the real world, and how effective they are in producing profitable signals to trade from. So here is a practical example of how we applied and profited from this relationship in the real world. In late August 2010 we noticed that US real rates were falling far more rapidly than gold prices were rising. We also held the view that the Federal Reserve was going to embark on another round of quantitative easing within the next three months; therefore we did not see US real rates rising, given that the Federal Reserve would likely begin buying bonds heavily. From this we inferred that gold prices we set to stage a major rally to a new all time high, so signalled to our subscribers to buy a great deal of out of the money GLD call options to benefit from this rise (more details can be viewed in our full trading records, which is published on our website). We banked profits in percentage terms, ten times higher that the gains made by gold or the HUI gold mining index during that period, and when the market began to price in QE2 and US real rates fell further we bought again and enjoyed a similar return.
We are now of the opinion that US real interest rates are low in relation to the current gold price and are heading lower, therefore we see the gold price going still higher to $1800 within the next six months. Of course this works both ways, so if US real rates begin rising there could be a serious correction/further consolidation in gold. We are monitoring this situation closely and adjusting our position (and that recommended to our subscribers) accordingly. However we are struggling to see what could either seriously dampen inflation expectations or cause a substantial rise in US interest rates, hence why we are very bullish on gold at present.
If the economic situation improves, inflation expectations will rise. If the economic situation deteriorates then central banks will likely combat this with further easiing of monetary policy, which will be explosively bullish for gold prices. Further loosening of US monetary policy could come in the form of QE3 or perhaps a cap on longer term rates, which could be achieved by the Federal Reserve stating a target two year interest rate. We think that being long gold is the best way to play this move and that options offer the best trade from a risk-reward perspective. Our options trading service has outperformed gold, the HUI and also the doubled leveraged gold ETNs.
Hopefully this article will have drawn the reader’s attention to this relationship gold has with US real rates and we suggest that it form a pillar of your fundamental analysis with respect to gold. This is not to say other relationships such as the USD and gold are not to be noted, they should be, but in conjunction with US real rates. By pulling all these relationships together one can get a better picture of where the yellow metal is headed and when it is going to move, which ultimately leads to more profitable trading.
As mentioned before, we are of the opinion that gold prices are heading to $1800, so if you would like to take full advantage of this then please visit our website www.skoptionstrading.com to sign up to SK OptionTrader, our premium options trading service that costs just $199. We have closed 81 trades with 78 winners, for an average gain of 40.41% per trade including the three losing trades. We run a model portfolio for subscribers to follow if they wish, with suggested capital allocations to each trade and this model portfolio has an annualised return on investment of 117%.
We think that options are the best way to benefit from this coming major rally in gold prices. We trade options based on GLD, so one can execute the same trades with a simple US brokerage account that has stock options trading. All of our trades have limited downside and given the potential explosive upside in gold over the coming months, we think the risk-reward in some options trades at present are too good to pass up. On 1st July we recommended such an opportunity which is now showing a 210% profit in two weeks, and we think it could triple again from here. So, to find out what this trade is and others like it sign up now as we are about to place a number of trades that we think will prove to be extremely profitable over the coming months.
The charts in this article are plotted with the gold price in US dollars on the left axis and inverted US real interest rates on the right axis to show the negative relationship between the two. The US real rates data is taken from the US Treasury Real Yield Curve and are commonly referred to as "Real Constant Maturity Treasury" rates, or R-CMTs. Real yields on Treasury Inflation Protected Securities (TIPS) at "constant maturity" are interpolated by the U.S. Treasury from Treasury's daily real yield curve. These real market yields are calculated from composites of secondary market quotations obtained by the Federal Reserve Bank of New York. The real yield values are read from the real yield curve at fixed maturities, currently 5, 7, 10, 20, and 30 years. This method provides a real yield for a 10 year maturity, for example, even if no outstanding security has exactly 10 years remaining to maturity. Gold data is taken from the London Bullion Market Association.
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