This year’s record run for gold prices met some resistance over the past week as traders took profits following the release of faster-than-expected inflation data in the U.S.
The yellow metal surged from around $1,800/oz on July 16 to as high as $2,075 on Aug. 7—a record level—before tumbling as low as $1,863 on Aug. 12.
Prices have since rebounded to around $1,950, leaving gold-tracking ETFs like the SPDR Gold Trust (GLD) and the iShares Gold Trust (IAU) up by 30.5% on a year to date basis, handily outperforming the 4.7% gain for the S&P 500.
Gold prices backtracked last week after U.S. government data showed a more rapid than expected increase in wholesale and consumer price inflation.
The Core Producer Price Index in the U.S. increased by 0.5% month over month in July, according to the Bureau of Labor Statistics, the fastest increase since 2018. At the same time, the Core Consumer Price Index jumped by 0.6% in the same period, the biggest monthly increase in the gauge since 1991.
That spurred U.S. interest rates to perk up from all-time lows. The U.S. 10-year Treasury yield briefly topped 0.72% last Friday, more than 20 basis points higher than its low point.
However, the rally in yields was capped by continued buying of Treasuries by the Fed, which has targeted $80 billion of purchases per month.
US 10-Year Treasury Bond Yield
Negative Real Yields
Gold has benefited from this year’s plunge in interest rates, which makes the metal more attractive as an alternative safe haven. In particular, many investors have pointed to the decline in real interest rates, which account for inflation, as being the predominant driver of gold’s ascent to record highs in 2020.
While the nominal 10-year Treasury yield currently stands at 0.69%, Treasury inflation-protected securities (TIPS) of the same maturity—which are indexed to inflation—currently offer a real yield of minus 0.97%.
10-Year TIPS Real Yield
That’s the lowest real yield since TIPS were first issued in 1997, and suggests that after adjusting for inflation, investors in Treasuries are expected to lose money.
The difference between the real yield on TIPS and the nominal yield on ordinary Treasuries is considered the breakeven rate, or the market’s expectations of inflation over the next 10 years. That figure currently stands at 1.66%, completely recovering to where it was before the coronavirus pandemic struck.
US 10-Year Breakeven Inflation Rate
It’s pretty clear what is happening here. Due in large part to trillions of dollars’ worth of stimulus programs unleashed by U.S. fiscal and monetary authorities, investors’ inflation expectations have risen. However, interest rates have not been able to adjust upward in turn due to the Fed’s massive bond buying program.
Rising inflation expectations without a corresponding tightening in yields to offset those expectations has been bullish fodder for gold, which is seen by many investors as one of the predominant inflation hedges.
Gold Prices (Blue) vs Real Yields Reversed (Orange)
Real yields have been multiplied by -1
Not The Only Driver
While this year’s drop in real yields and rise in gold prices have closely tracked each other, correlation does not imply causation. Real yields may be one factor driving gold, but they certainly aren’t the only one.
Tied more closely to the actual supply and demand of gold are gold-backed exchange-traded funds. Inflows and outflows from these ETFs, which hold physical gold, have a direct impact on gold demand. Nearly $50 billion has flowed into global gold ETFs so far this year, according to the World Gold Council, more than four times the pace of last year. Gold purchases by these funds have accounted for 35% of total gold demand in 2020.
Torrid demand from gold ETFs has helped offset a 46% plunge in gold jewelry demand and a 39% drop in central banking purchases.
Unsurprisingly, gold prices have tracked the amount of gold held by ETFs quite closely. In this case, correlation is more likely to imply causation, because gold ETFs have a direct impact on gold demand in the physical market.
This is not to say the aforementioned decline in real yields is not playing a part in gold’s ascent. It may be a large factor in driving investors into gold ETFs in the first place, but there could be other factors pushing investors to buy—such as economic growth fears or geopolitical concerns.
Gold Prices (Blue) vs Total Gold ETF Holdings (Orange)
Another point to consider is that the gold market is global. While developments in the U.S. financial markets in general and U.S. Treasury markets in particular tend to have an outsized impact on gold prices, they aren’t the market’s only focus.
Even among this year’s gold ETF inflows, one-third took place in Europe, Asia and elsewhere outside of North America. Investors in those regions aren’t necessarily basing their buying decisions on U.S. Treasury yields. They may be more concerned with yield and currency movements in their own countries.
Then there are China and India to consider, which together make up more than half of global gold demand. Buyers in those countries aren’t likely to be hyperfocused on the U.S. Treasury markets.
Again, real U.S. interest rates may be one factor driving gold prices this year, but it is certainly not the only factor.