Wednesday, 16 November 2016

Relationship Between the Gold and Bond Market

 Gold Price Rise in High or Low Inflation Environment 

We heard that gold is an inflation hedge. In other words, it's held by investors during high inflation environment to protect them from devaluation of the dollar.

Since the bond market is the single largest financial market in the world, what takes place in bond market will have consequences for other, small markets such as the equity or gold markets. I.e. money that's leaving the largest financial market - the bond market - will flow into other markets and push its prices higher, and vice versa.

Because the bond market is so big compare to gold market, its tiny flow from bond market can cause a flood in gold market. If the bond market is a big cap, then the stock market is a mid-cap and gold market is a small cap, and silver is a micro-cap stock. It doesn't take much money to drive the micro-cap stock to extreme highs and lows. The same can be said about the silver market.

This article explains why gold can rise in price in both period of high inflation (e.g. 1970s) as well as dis-inflation or low inflation or even deflation environment (like the one we faced in the 1st half of 2016 where gold price soared considerably).

The inflation rate needs to rise above the bond yields to get a positive carry trade. What is a positive carry? Or negative carry for that matter?

If somebody is holding a Ten-Year Treasury Note with yield of 1.5% (or $TNX = 1.5%) for a year, and the inflation of that year is 1.7%. This means that the bond holder is losing 0.2% for the year. Because while he makes 1.7% of return on the bond he holds, he actually loses out it to inflation as his money depreciates. He loses exactly 1.7% - 1.5% = 0.2%.

This is a negative carry for the bondholder as he loses 0.2% as he holds the bond for the year. This is a guarantee loss. Clearly a bad investment.

Another way of viewing carry is Real Yield.

Real Yield = 10 Year Treasury Note Yield ($TNX) - Inflation Rate.

So you can lose money too by holding 10 Year bond even when inflation is low or falling as in the case of the period from 2013 to 2016.

Interest rate chart (2006 - 2016)

If you look at the $TNX and gold charts below, $TNX has been fallen since the start of the year 2016 and bottoms on 6 July at 1.33%. At the same time, gold is rising from the start of year, and peaks at, guess what?, also on 6 July where $TNX bottoms.

The price of gold has been falling from the peak of 6 July, and $TNX has been rising since then. In other words, when $TNX rises, gold falls, and vice versa. This close relationship between these 2 markets aren't coincidental. Both gold and $TNX are seen as safe haven asset. They tend to both rise and fall together (in a negative correlation). Or that bond price and gold price rise and fall together in a positive correlation. When bond prices fall, gold prices tend to follow, as far as the market see them as safe haven plays.

Because they both are safe haven or risk-off plays, they tend to compete for investment money. Therefore when Real Yield is negative, it's therefore better to hold gold than $TNX, and vice versa. Because in a negative Real Yield environment, bond is a losing proposition. So gold is a better protection.

One year $TNX chart as of 16 Nov 2016
One year $TNX chart as of 16 Nov 2016

One year gold price chart as of 16 Nov 2016
One year gold price chart as of 16 Nov 2016

By now, it should be more than clear that if you flip the $TNX chart, you'll get the gold chart (with different labels, of course). Is that true? Are they mirror images of each other? Yes, but not quite. Close, but no cigar.

While the $TNX's top matches gold's bottoms, and vice versa, they're not symmetrical.

Look at the 2 tops of $TNX, they're almost at the same level. I.e. $TNX has gone back up to the start of January level. And yet, this is important, gold's November bottom is considerably higher than January bottom. In other words, gold has outperformed $TNX. More importantly, this is gold market saying that it's anticipating coming inflation, and pricing it in.

This seems to suggest that gold gives you a better returns than $TNX as a safe haven asset. At least it's seen in the 1st half of 2016). But i think this is true in general, It's true beyond this 6 months period.

You can have negative Real Yield when inflation is low or high. Similarly, you can have Real Yield negative when $TNX is low or high. But when $TNX is negative, there's very good chance that Real Yield would be negative, such as some bond yields in parts of the world (e.g. JGB or German Bund, etc).

If Real Yield is negative, gold will rise. If Real Yield is trending negative such as the 1st half of 2016, gold will trend positive. And when Real Yield is trending positive or less negative, such as the 2nd half of this year, gold will fall.

On 16 Nov (the last date on the charts), as inflation rate is 1.5%, but $TNX has spiked to 2.238%. Clearly, inflation rate is LOWER than $TNX. Real Yield becomes increasingly more positive, and so gold fell.

So even if $TNX continues to go up, say to 3% by next year, but if inflation rate goes up much higher from here, say 3.5+%, then gold will soar because of the negative Real Yield.

 The Fed's Golden Guarantee 

So how can i be sure that inflation rate is always HIGHER than TNX? Don't worry, the Fed will make sure of that. This is their policy. The operations of the economies of the world require this same policy. So an investment in gold is safe because of the Fed's (and all central banks') guarantee of behind the curve on inflation.

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