Judging by past evidence, Donald Trump’s motto could be “Build it then gild it”. Trump’s penthouses, planes, casinos and hotels tend to have a distinctly shiny hue. So perhaps it was apt that the gold price spiked on news of his election win. But then the speculators remembered some other things, and gold fell again. Has Trump taken the shine off gold? Or are there more fundamental forces to think about?
On 9th November, that day following the US election result, the gold price jumped to US$1,307/oz, up 2.7%. BullionVault reported that its customers bought three times as much bullion as they sold that day.
Donald Trump has a big building plan. He wants to invest in US infrastructure.
Perhaps the world’s investors imaged he would do the same as he always does. Build some big stuff and cover it all in gold leaf. Or (much more likely) it was a knee jerk reaction to a widely unexpected result.
Change! Uncertainty! Buy gold!
But, after a short time, the speculators had a chance to actually look at – or rather look up – what he plans to do. Cut taxes and spend more – at least at first.
That amounts to a huge fiscal stimulus, which is inflationary, which means higher interest rates are on the cards. Bubbly bond markets fell hard as bond yields rose from next to nothing (or less than nothing) to slightly more than next to nothing. (For more see: “Is Trump good news for US stocks?”)
Also the US dollar rose. The expectation of higher interest rates makes it more attractive. Gold usually goes down when the dollar rises.
So far, so good. But hold on, isn’t higher price inflation supposed to be good for gold? Isn’t there a thing called the “golden constant” that means gold’s price rises over time with inflation?
Well yes, in the ultra long run. In fact there’s a case to be made that conditions are still in place for the gold price to rise significantly faster than inflation, just as it’s done over the past 40 years.
By 1976 the gold price had reincorporated the inflation denied it for the previous 38 years. Between 1933 and 1971 the price was pretty much fixed at US$35/oz. Since 1976, gold has gone on to beat official US CPI by 2.1% a year (that’s 5.7% a year for gold versus 3.6% a year for CPI).
(Side note: despite the gold standard, US dollar consumer prices still rose by 3% a year on average between 1933 and 1971. Having a currency pegged to gold doesn’t mean prices don’t rise. Even using gold itself may not help. Just ask a 16th century Spaniard.)
Is this above inflation result because the official inflation figures are understated? Of is it because there are other things driving gold? Take your pick (it’s probably a bit of both). Either way I expect gold to continue outperforming official CPI over the long run.
In any case, in the short run there are factors other than current inflation rates that can be more powerful drivers of the gold price.
First of all is where the current price sits in relation to the overall inflation (plus a bit) trend. Put another way, taking a long view, is gold cheap or expensive in the present? Therefore, is it more likely to go up or down?
Second is the issue of something known as the “real yield”. Put simply this is what bond investors will make, at current market yields, above their expectation for future inflation. Sometimes, in a bubbly world, the real yield can even be negative.
The real yield is also the yield quoted on US treasury inflation protected securities, or TIPS. They pay investors future CPI plus or minus something, that something being the real yield.
(For the technically minded you can work out the market’s inflation expectation like this. A standard, fixed coupon 10 year US treasury bond currently yields 2.26%. Ten year US TIPS yield 0.36%. Therefore the market’s US inflation expectation for the next decade is the difference, or 1.9% a year.)
There’s quite a bit of historical evidence that the real yield has a big effect on the gold price, at least in the short run. Unlike bonds, gold doesn’t pay a coupon. So if the real yield is high or rising then owning bonds becomes more attractive relative to gold (bonds beat inflation). But if the real yield is low or falling – or even better negative – then gold attracts more investor attention. Or so the theory goes.
(For those interested in more detail about gold’s short term prospects I recommend checking out Charlie Morris’s analysis for Atlas Pulse. In there you’ll also find a lot about Bitcoin and other crypto currencies.)
Over the past month – and especially since Trump’s win – the real yield on US treasury bonds maturing in 10 years increased from 0.15% to 0.36%. The bond market’s inflation expectation for the next decade increased from 1.66% to 1.9%.
A real yield of 0.36% is still very low by historical standards. Something around 2% is more “normal”. But the point is it’s been rising, which has weighed on the dollar gold price. As I write it’s trading at US$1,226/oz, which is 6% down from its post-Trump peak.
(Although it’s still up 16% from the December 2015 low, making gold one of the best performing assets this year.)
Here’s a chart showing historical 5 year real yields going back to the start of 2003. (I chose the 5 year bonds because this is the longest data set I could find.)
Right away you can see a few clear things. Before the financial crisis – when markets were more normal – the 5 year real yield was mostly between 1% and 3%. The crisis sent it haywire, first plummeting, then spiking, then falling. It went strongly negative between mid-2011 and mid-2013, and has been bumbling around close to zero since then.
Some of you may have noticed something. Gold was in a major bull market from 2001 until 2008, when the real yield was strongly positive. It was also in a bear market from mid 2011 until late 2015, which coincided with negative real yields.
So you could reasonably conclude that the theory about real yields driving the gold price is bunkum. Otherwise how can gold rise when real yields are high and fall when they’re negative?
And you’d be at least half right to think that. It’s not that gold is immune to changes in the real yield – at least in the short term. It’s just that sometimes even bigger factors come into play.
Here are some of the big things that drove the gold price between 2001 and 2008:
- After the the bursting of the 1980 speculative gold bubble there was a 21 year bear market. By 2001 gold was dirt cheap on a long term, inflation-adjusted view.
- Emerging market economies grew strongly, as did their private wealth, as did their money supply. Much of that money found its way into gold.
- In China, the Shanghai Gold Exchange opened in October 2002. China was getting on the case.
- China’s ban on private ownership of gold bullion, in place since 1950, was lifted in 2004. It wasn’t long before China overtook India as the biggest buyer of physical gold.
- SPDR Gold Shares (NYSE:GLD), the first of many gold-backed exchange traded funds (ETFs), was launched in November 2004. This made investment in gold much easier.
- The internet made it easy and cheap for private investors to buy and sell gold bullion stored in secure vaults around the world. For example, BullionVault – a pioneer in this area – opened for business in 2005.
- There was a general boom – even bubble – in commodity prices due to the China effect and the so-called “super cycle”. Investment bank Goldman Sachs infamously predicted US$200 oil in mid-2008 (just before the crash). Money flows into general commodity funds, which owned gold, dragged precious metals along for the ride.
- Gold was becoming more expensive to mine and transport, partly because of the high and rising oil price.
So why did gold fall after 2011? Firstly the price got ahead of itself, on a long term, inflation-adjusted view. Put simply, gold at US$1,837 was expensive. Secondly, as the price fell, investors in those gold ETFs started to pull out in droves, driving it down further.
Where do we go from here? I believe there are several powerful forces that will keep driving the gold price up over the long term. In fact I expect gold to continue to outperform inflation by a significant margin, as it has done over the past 40 years.
Trump’s plans, and rising real yields in the bond markets, could hold down gold in the short term. That’s what will drive speculative activity.
But there are still plenty of good reasons to own a chunk of gold for any investor with a medium to long term outlook. Gold will keep its shine.
More on that next time…
Stay tuned OfWealthers,
Our goals are simple. We want to help private investors do two things:
Build wealth. Invest with success.
Twice a week we help thousands of subscribers who share these goals with our free publication, the OfWealth Briefing.
As well as everything published on our website, subscribers receive additional exclusive comment and analysis that is unavailable anywhere else.
New subscribers will also receive several free special reports as soon as they join up. Click on the link below for more details and to start receiving your premium OfWealth content.