Three Drivers of Gold, Second Look / Commodities / Gold and Silver 2018

Let’stake a second look at the drivers of gold. We have already stated that thethree most important factors are: the real interest rates, the U.S. dollar,and the risk aversion.Fair enough. But we have presented just the first approximation. We need to digdeeper. Why?

First, all these variables are connectedtogether. Many analysts and investors who listen to them often make amistake, assuming that the forces which push one driver have no effect on theother inputs into the value of gold. This is a dangerous delusion, which may exposeinvestors to heavy losses.

Forexample, low confidence in the economy should also increase the real interestrates and weaken the currency (however, the U.S. dollar is also seen byinvestors as a global safe haven, so during market turmoil gold can actuallyrise in tandem with the greenback, as at the turn of 2008 and 2009).

Andwhen the U.S. real interest rates fall, it should weaken the greenback relativeto other currencies, including gold, in line with the interest rates parity.Very low real interest rates may also increase uncertainty (as investors areafraid of secular stagnation then, or they worry that rates will have to reboundone day – indeed, ZIRP and NIRP diminished trust in the economic prospects, at least initially).

Lastbut not least, when the value of the U.S. dollar fluctuates wildly, it canincrease the risk aversion. The rise in the uncertainty should boost the realinterest rates, as they can be perceived as the sum of the risk-free rate andthe risk premium.

Second,we have analyzed the direct drivers of the gold prices. However, we haven’t yetdiscussed the indirect factors, or drivers of the drivers. We mean here thatexplaining the move in gold prices expressed in the U.S. dollar by fluctuationsin the U.S. dollar actually gives little information to investors. Investors deserve a better understanding ofwhat the underlying drivers are.

Forexample, the real interest rates are nominal interest rates adjusted forinflation. And the nominal interest rates have two components: the risk-freerate and the risk premium. The risk-free rate is what investors can make on along-term, default-free investment. The yield of 10-year U.S. Treasuries isusually used as such rate, while the risk premium is taken from the spreadsbetween the U.S. government bonds and risky securities. However, the riskaversion, or the perception of uncertainty is something more and it probablycannot be measured accurately, as it has some subjective components.

Thecase of the U.S. dollar is more complicated, as we should take many factorsinto account, such as: the level of interest rates,the level of risk aversion (the greenback is also a safe-haven currency),the U.S. monetary, fiscal and trade policies, or inflation.

Inflation– let’s focus on that for a while, as gold is widely seen as an inflation hedge.How does it affect the price of the yellow metal? Well, the higher inflation,the lower real interest rates are (and the vice versa). And when Americanprices go up, the purchasing power of the U.S. dollar erodes. Finally, thesurge in inflation increases uncertainty. Therefore, the metal shines duringperiods of high and accelerating inflation, as inflation affects the goldprices via the interest rate channel (it lowers real yields), the currencychannel (it weakens the greenback), and the risk aversion (it elevates thegeneral uncertainty in the economy). Hence, we haven’t distinguished inflationas the driver of the gold prices, but itinfluences them indirectly, affecting all the three main direct factors.

Tosum up, investors shouldn’t make the frequent analysts’ mistake and focus onlyon one piece of gold’s value puzzle. When we model the price of gold, wesimplify reasoning and hold many factors constant. But in the real world, thereare no constants. We don’t live in physical laboratory, but in the complexeconomies, where everything is interconnected. All gold drivers are connected together and almost any macroeconomicchange – like a financial crisis, a tax reform, or rising yields – affectsall of them, making the fundamental analysis very challenging. Hence, the moresophisticated version of Golden Triad of Gold’s Drivers should look like thediagram below.

Diagram1: A More Sophisticated Version of the Golden Triad of Gold’s Drivers.

Let’stake the issue of rising Treasury yields.If this increase is real-growth driven, it is a net negative for the goldprices. But if we see an inflation-driven increase in interest rates, theyellow metal should gain. Which narrative is true? We believe that the former –inflation is on the rise, but not dramatically – and the real interest ratesare also climbing. Nevertheless, this example clearly shows that investors should always adopt a broad viewand work through the net effect.

If you enjoyed the above analysis and would you like to knowmore about the gold ETFs and their impact on gold price, we invite you to readthe April MarketOverview report. If you're interested in the detailed price analysis andprice projections with targets, we invite you to sign up for our Gold & SilverTrading Alerts . If you're not ready to subscribe at this time, we inviteyou to sign up for our goldnewsletter and stay up-to-date with our latest free articles. It's freeand you can unsubscribe anytime.

Arkadiusz Sieron
Sunshine Profits‘ MarketOverview Editor

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