This number determines the gold price

This number determines the gold price

Take a guess at how many emails I’ve gotten with the word “gold” in them in the last week.

Now, bear in mind that I subscribe to every financial newsletter there is. So it’s a big number…

But still. I was surprised. I’d never have guessed I get 93 gold-related emails a week.

It goes to show gold has a grip on investors’ imagination. They want to know more about it. They want to understand it. They want to know to use it.

Recently I wrote about interest rates. Today, I want to extend my grand theory of interest rates into gold. Because understanding interest rates is the key to understanding gold.

It’s all about real interest rates

I said central banks have limited control over interest rates, that central bankers are free to steer rates the same way a driver is free to steer his bus off the road…

I said interest rates are really determined by the level of inflation and growth in the economy…

I said interest rates are probably going to stay fairly low for the next ten years…

And as a consequence, you could expect stock prices to stay relatively high.

I didn’t mention it at the time, but interest rates are crucial for gold. Historically, the real interest rate — which is the interest rate, minus the inflation rate — has very closely tracked the gold price.

I’ll show you a chart in a moment so you can see this for yourself. But why does this happen?

The real interest rate is a sort of barometer for the overall health of the economy. A high real interest rate means “I can invest my money and get a good rate of return, and when it’s time to spend it I’ll be able to buy more stuff”. Because of course, buying more stuff is the name of the game. High nominal interest rates and low inflation is the dream scenario, the sign of a healthy economy.

Sometimes interest rates are high but inflation is high too, like in the 1970s. Or sometimes inflation is low, but interest rates are low too, like now. Neither of these are ideal. In both scenarios, the real interest rate will low. Because when nominal rates are low or inflation is high, you can’t invest money, wait a while, and then use it to buy more stuff. An unhealthy economy.

Gold does well when the economy is unhealthy, and badly when it’s healthy.

When real rates are high gold goes down. Then real rates are low it goes up. It doesn’t really matter what’s causing real rates to change — it could be inflation or interest rates, or both together — what matters is the combination of the two.

In recent times real rates were very low in the 1970s due to high inflation — gold went up. Then inflation fell a lot and interest rates didn’t move much, from the 1980s through to 2008 — gold went down. Then nominal rates fell a lot, starting in 2008 — gold went up.

Here’s a chart showing how the two numbers interact. It shows the price of inflation-protected treasury bonds, which are a proxy for the real interest rates.

A 1% change in the TIPS yield has moved the gold price by (roughly) $400/oz since the data series starts in 2003.

This makes perfect sense. Gold is an old store of value, but it doesn’t pay any returns. So, when the returns on offer in the market dry up, gold gets more appealing.

To put it another way: the real interest rate, and the TIPS spread, is a sort of proxy for the amount of extra stuff you can buy in the future if you forego buying stuff now. When the market is booming and there’re loads of investment opportunities, that pushes interest rates up (more stuff in the future). When inflation is high, the price of future stuff goes up (less stuff in the future). The real interest rate puts those two numbers together.

The lower that real interest rate number is (ie, the less future stuff-buying you have to forego), the more you just want to put your money in gold, where at least it’ll be safe. Gold may not pay you any income. But it’s got a good long run record of holding its value.

All in all, gold is a sort of a barometer of the health of our contracts and law and promises based economic system. If the system is humming it should be able to generate 2% real returns for investors every year. If the system is broken in some way (either too depressed to generate returns, or too inflationary), that’ll show up in real interest rates. And gold will go up.

So there you have it. According to my theory, you buy gold when rates are about to drop or inflation is about to go up. When the system breaks down, gold keeps you safe.