Negative interest rates continue To break the gold pricing framework?

The analysis believes that the longer the TIPS yield remains below zero, the more likely it is that gold will decouple from it and move upwards.

Under the current framework, the value of gold is largely determined by the yield of the 10-year TIPS (U.S. Inflation-Protected Bond), but Jan Nieuwe nhuijs believes that this framework will be broken as TIPS yields remain below zero for longer and longer.

The three main stages of gold pricing

The dollar-denominated price of gold was negatively correlated with the ex-post real interest rate (nominal Treasury rate minus consumer price inflation) from 1968 to 2005, while since 2006 the negative correlation to the price of gold has become the ex-ante real interest rate (the expected real interest rate measured against the 10-year TIPS yield).

While the causal relationship between gold and TIPS yields (US anti-inflation bond yields) is difficult to prove, the correlation between the two is very strong and there is a "reasonable" explanation.

To understand the current framework, there are three phases worth exploring. The first phase was under the Bretton Woods system, when the dollar was equal to gold because the dollar was pegged to gold, which was priced at $35 per trove of gold. Shortly after World War II, there was little doubt about the stability of the dollar.

However, in the 1960s, markets began to worry about the depreciation of the dollar relative to gold because Americans printed too many dollars. There is a trade-off between holding gold and holding U.S. Treasuries, the only international reserve asset that cannot depreciate at will but does not generate gains, while U.S. Treasuries have gains but are denominated in U.S. dollars. U.S. Treasury yields and expectations of a depreciation of the U.S. dollar played a role in the market's decision to buy and sell gold.

The second phase began in 1968, when gold was allowed to float against the dollar on the free market. When investors expected inflation to rise (real interest rates would fall afterwards), they pushed up the price of gold as a safe haven. So when the Fed raises interest rates and inflation falls (real interest rates rise afterwards), investors sell gold to depress its price. Thus, from 1968 to 2005, there was a negative correlation between gold and the real interest rate after the fact. Treasury yields and inflation expectations play a role when the market decides to buy or sell gold.

The third phase began in 1997, when the United States introduced Treasury Inflation Protected Securities (TIPS), resulting in real interest rates in advance. In 2006, gold began to correlate closely with the 10-year TIPS yield.

The TIPS yield is the expected real interest rate. The TIPS yield formula is:

Expected Real Interest Rate = Treasury Yield - Inflation Expectations

i.e. TIPS yield = Treasury yield - breakeven inflation rate

A fall in tips yields pushes gold prices higher, and its rise causes gold prices to fall. Treasury yields and inflation expectations play a role when the market decides to buy or sell gold.

What exactly is TIPS?

First, the valuation criterion for nominal government bonds is the Fisher equation: risk-free interest rate = real interest rate + inflation expectations. And because U.S. Treasury yields are considered risk-free, because the U.S. government can print any amount of dollars to pay off its debt. Therefore, the above equation is equivalent to:

US Treasury yield = real interest rate + inflation expectations

According to fisher-pricer's equation, investors are free to buy and sell Treasuries. (This is theoretically the way it works, but in reality many financial institutions are forced by law to buy government bonds.) ）

For a 10-year Treasury note with a coupon rate of 3%, a coupon of 3% is paid each year and the principal is returned after 10 years. When inflation is higher than a U.S. Treasury holder expects, if he holds the bond until maturity, his return will decrease in real terms.

The existence of TIPS bonds, then, guarantees the actual rate of return for U.S. Treasury holders. Example: An investor buys a 10-year TIPS bond with a principal of $1 million and a coupon rate of 2%. At each coupon payment, the principal and interest on the bond are adjusted for inflation. Therefore, in relative terms, the attractiveness of TIPS bonds is much greater than that of ordinary US Treasuries.

Because TIPS bonds compensate for inflation, the more investors buy such bonds, the lower the yield on TIPS relative to nominal Treasuries until the difference between the two is balanced. That's why the difference between tips bond yields and nominal Treasury yields is called the "breakeven inflation rate."

Thus, the breakeven inflation rate reflects market-based inflation expectations. If the market expects annual inflation to average 1% over the next 10 years and a nominal interest rate of 3% on 10-year Treasuries, then the yield on a 10-year inflation-preserved bond will be priced at 2% (3%-1%).

The TIPS rate of return is also considered the actual rate of return in advance, so its formula is a rearrangement of Fisher's equations:

TIPS Yield (2%) = Treasury Yield (3%) - Inflation Expectations (1%)

Treasury yield (3%) = Real yield (2%) + Inflation expectation (1%)

If the market's inflation expectations are consistent with the difference between TIPS bonds and nominal bonds of the same maturity, then the returns on holding both bonds are the same. At this time, if inflation rises unexpectedly, TIPS, which can hedge inflation, will be better than nominal government bonds. Conversely, when inflation results are lower than expected, nominal Treasuries will outperform TIPS.

What happens if tips yields are negative? Bond buyers need to pay a premium upfront when buying bonds, such as a 10-year zero-coupon TIP with a yield of -1%, and buyers need to pay 110% of the principal first and receive 100% of the principal payment after 10 years, during which the principal will be adjusted according to inflation, but at maturity, the investor's actual yield is -1%.

Can this current gold pricing framework be sustained?

Beginning in 2006, gold prices rose as soon as TIPS yields fell, and vice versa. When real interest rates fall, the market sees holding gold as more attractive because it is the only international reserve asset without counterparty risk.

But curiously, this correlation did not change when tip yields entered negative territory. When the TIPS yield fell from -0.5% to -1%, the gold price reacted the same as when the TIPS yield fell from 1% to 0.5%.

What's even stranger is that under the current framework, if the 10-year TIPS yield remains unchanged at -1% for many years, bondholders will face serious losses, and if the gold price has been fluctuating around $1800/oz, it will be impossible to hedge the losses caused by holding bonds.

Another issue to consider is that the U.S. federal debt is growing much faster than total gold reserves. The U.S. federal debt has doubled over the past 10 years, but total gold reserves have grown by only 17 percent. At present, the yield of TIPS is the same as that of 10 years, which is around -1%, so the loss of earnings in nominal dollars is twice that of 10 years ago, and the nominal gold price is equivalent to a 17% increase, which seems asymmetrical.

Given the record 370% of total U.S. debt to GDP, the 10-year TIPS yield is likely to remain negative. In this environment, the U.S. government is unlikely to allow nominal interest rates to rise sharply. At the same time, money printing and supply chain issues have triggered inflation.

Therefore, Jan Nieuwenhuijs believes that the longer TIPS yields remain negative, the more likely it is that gold will decouple and move upwards. Another important factor is that in many countries real interest rates after the fact have been negative for nearly a decade. As a result, people see stocks and real estate as "perfect hedging products" because these assets continue to rise and pay dividends or rents.

However, these markets are in a bubble, and although the bubble will last longer than expected, there will always be a time to burst in the end. At that point, investors will be looking for another store of value, and when the stock market plummets and government bonds fail to provide positive real returns, investors will turn their attention to gold.

This article is derived from Golden Ten Data