“Gold… To invest or not to invest?”
Now, that is the golden question, if you will.
The answer to this question, however, is not exactly as clear cut as you might expect.
Over the years, there has been great debate over whether or not gold is a profitable investment. And indeed, if that’s what you’re looking for—a steady stream of profits generated by interest-based returns or dividends—then we urge you to take a step back, because owning gold doesn’t quite do that.
In fact, some critics may even claim that it’s more costly to own gold, since there’s now an added cost of storage you have to factor in for the safekeeping of your gold. Even so, that’s hardly an adequate reason to shelve gold indefinitely.
Traditionally, people own gold as a protection against tough times. For instance, in the event of recession or other financial emergencies, owning gold—a highly liquid, tangible asset—might just save you from falling into a dark pit of debt.
But there’s more to gold than just being your ‘rainy day’ investment. The fact that it has been around for over thousands of years and its value has more or less remained stable contributes significantly to the argument that favours it. Say whatever you want about gold… It has outlived more than a millennium’s worth of man and their man-made currencies. And, if we’re to follow this precedent, gold will likely continue to do so until the end of time. (In other words, you shouldn’t rule out owning or investing in gold. Rather, you should concern yourself with when is a good time to buy or sell gold).
Since the pricing of gold is relatively time-sensitive, then it’s important that we approach this question by assessing equally time-relevant economic variables such as the US dollar, inflation, interest rates and the market demand for safe assets. In the case of gold, inflation and nominal interest rates are usually the most important factors to look at, as our studies have found that one of the strongest predictors of gold prices has always been the inverse relationship between the price of physical gold and real interest rates.
(Note: While investing in gold does not generate interest-based returns, we use the interest rates offered by other investment products such as equity, bonds and bank deposits as a parameter to help us decide between which is the more profitable option in the market at a given time).
Inflation
According to Investopedia, inflation is “the rate at which the value of a currency is falling and consequently the general level of prices for goods and services is rising”. When there is an inflation, it usually results in a decline of purchasing power. However, gold being classified as an “inflation-hedged asset” or is often regarded as a “store of value” is almost always protected against the adverse effects of inflation. In other words, if there’s ever a good time to put your money on gold, it’s when the market is experiencing a relatively high inflation.
Nominal Interest Rate
Investopedia describes nominal interest rate as the interest rate prior to its adjustment for inflation. We can take this to mean the percentage of returns/dividends offered by central banks in the current market, which we in turn, use as a comparative measure against the price of gold. Normally, it has been observed that gold has a negative correlation with nominal interest rate—i.e., when the nominal interest rate offered by central banks is high, the price of gold drops, and when nominal interest rate is low, the price of gold rises.
Therefore, it can be inferred that it is best to invest in gold when the nominal interest rate in the market is low since there’s not much to profit from in terms of other types of investment. On the other hand, gold, whose price tends to rise when markets are volatile, is the far more attractive option to help balance out any potential risks or losses.
Real Interest Rate
If nominal interest rate refers to the interest rate before inflation-adjustment, then real interest rate is the interest rate after inflation-adjustment. Typically, the formula used to derive real interest rate is the nominal interest rate subtracted by inflation. So, for example, if the nominal interest rate is 5% and the inflation is 3%, then the corresponding real interest rate is approximately 2%.
Similar to nominal interest rate, it has been found that a very strong negative correlation exists between real interest rates and gold prices (as can be seen in Chart 1). This is because what drives down real interest rate (lower nominal interest rate and higher inflation), conversely drives up the price of gold, and vice versa. Chart 2 better reflects this by using an inverted TIPS versus actual goal prices.
TIPS, abbreviated for Treasury Inflation Protected Securities, is an instrument that is used as a proxy for the real interest rate. As inflation rises, TIPS adjust in price to maintain its real value.
Chart 1: Gold prices versus Yield on 20-year TIPS
Data Source: Bloomberg
Chart 2: Gold prices versus Yield on 20-year TIPS (Inverted)
Data Source: Bloomberg
Applying these concepts…
“So, is now a good time to invest in gold?”
Going into the next two years at the very least, we foresee that real interest rates are likely to reduce from their current levels. This certainly concurs with the move undertaken by the majority of central banks worldwide: keeping monetary policies loose and refraining from increasing nominal interest rates.
At the same time, yields on many bonds in the marketplace are gradually being nudged down to reflect the reality of the declining economy, marked by an increase in the number of supply chain disruptions, higher costs of doing business, re-opening of economies and gradually increasing consumer and producer prices. All these point to a sharp increase in inflation, which can well push real interest rates deep into negative territory.
Furthermore, in a major development in the monetary framework, as announced by the U.S. Federal Reserve (Fed) in late August 2020, enforcing a flexible 2% average inflation target (FAIT) and affirming that they will no longer pre-emptively raise interest rates to counter perceived inflation risk, effectively means that nominal interest rates will be kept “lower for longer” while inflation will be allowed to run “moderately” above the current inflation target of 2%—two paths that are almost certainly to lead to a further decline in real interest rates.
So, what does this mean for gold prices?
Given the tendency of gold prices to share an inverse relationship with real interest rates, this means that a drop in the latter will very likely result in higher gold prices in the next 12-24 months. Banking on this probability coming to fruition, our verdict is, “Yes, now’s definitely a good time to seize the golden path.”
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