The price of gold reached a new all-time high in 2020. Fear of higher inflation and the Fed’s opening of USD swap lines with the major central banks in the world led to a steady downtrend in the greenback.
Fast forward ten months, and things changed. While the fear of inflation persists, the price of gold corrected several hundred dollars from the 2020 all-time high.
Traders willing to buy and own gold in their portfolio should be aware of one of the tightest correlations in financial markets – the one between the price of gold and the U.S. 10-year real rates. It is the correlation between the two assets that puts pressure on the price of gold. In other words, despite some bounces here and there, unless the correlation breaks, the price of gold will remain under pressure.
If we look back to the last decade, the correlation held remarkably. Hence, why should it break now? What if it does not?
Gold, Debt, Yields – A Trio to Consider When Investing
The chart above reflects the inverse correlation between gold and the U.S. 10-year yield. In other words, when yields are rising, gold declines – and the other way around. Because the yields are inverted, the chart shows the two financial assets as tightly correlated.
Yields represent the expected return investors have when buying a bond. The higher the yield, the better, but also the riskier the bond. Typically, high-yield bonds are junk bonds, while the so-called risk-free rate is the U.S. 10-year yield. Therefore, when the yields are rising on the risk-free instrument, the world is listening.
The pandemic triggered massive monetary and fiscal stimulus in the United States. At least in the fiscal space, the easing dwarfs anything seen in other parts of the world. Yet, with it, comes higher debt.
America runs a deficit, and the money it spends is borrowed. Literally, it means that it issues bonds to finance its deficit. Or, it issues new debt to finance the deficit and the new fiscal easing measures.
However, the lower the yields, the less attractive the bonds are. Hence, America must let the yields on the risk-free asset rise, to make the bonds attractive to investors so as to find buyers for its debt.
Based on the correlation presented at the start of this article, this alone is enough to put tremendous pressure on the price of gold. Higher gold prices come with lower yields. Should the Fed let the yields rise some more (and it may not have a choice), the price of gold will have a hard time bouncing from the lows.