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US Real Interest Rates Indicate Gold Slightly Undervalued

In this update, we look at the latest trend emerging in US real rates. US real rates continue to fall and as a result we remain bullish on gold.

We have covered the dynamics of the relationship between gold and U.S. real rates before, but for new readers and those wanting a refresher, here’s an excerpt from a previous article:

Gold investors tend to focus overwhelmingly on the relationship between the US dollar and gold, citing that a lower dollar leads to higher gold prices in US dollars. Whilst this may be generally true, there is another relationship that does not get as much attention as we believe it deserves, and that is the relationship gold has with US real interest rates. For the first few years of this gold bull market, it was sufficient simply to acknowledge the USD down, therefore gold up dynamic, but now things have changed. Over the past couple of years gold has rallied when the greenback has been making gains, as well as when it was weakening, therefore investors must now take note of the inverse relationship between US real interest rates and gold, which has been observed consistently over the last couple of years. 

The basic fundamentals behind this inverse relationship are that when US monetary policy is looser, real rates fall and therefore investors buy gold for a number of reasons.

Firstly, lower real rates could imply higher inflationary expectations in the future therefore gold is bought as a hedge against this possible inflation.

Secondly, lower real returns in Treasuries drives investors into risk assets in search of a higher return. This also sends gold higher but it also sends most commodities, risk currencies and equities higher too.

Thirdly, lower real returns on Treasuries reduce demand of US dollars, causing the dollar to fall and therefore the gold price to rise in US dollars.

Finally, looser monetary policy implies that the economic situation is not as rosy as many would like to believe, so if the Federal Reserve acts by loosening monetary policy and driving down real interest rates then that send a message that the economy is in a bad place therefore investors buy gold as a safe haven asset. There are probably many more reasons for this relationship, but we have just tried to cover the main ones.”

We believe the above explanation of U.S. real rates is the key tool for predicting gold movements. Our analysis and subsequent forecasts have been proved correct in the past and our current view is this:

In the past few months we have observed further deterioration in 10 year U.S. real rates to their current level of 0%.

As noted this is a bullish sign for gold. We would expect gold to have risen over this period to about $1800-$1900, but it is currently lagging below $1700/oz. For this reason we currently see gold as slightly undervalued, however not considerably. Any short term weakness will see us adding to our positions.

The situation in Europe looks unlikely to improve in the short to medium term. Economic reform is in the works, but this has a long term focus and will not have any effect on the underlying debt issues currently upon us. Any solution arrived at by the ECB will only buy time; the problems at hand will not be resolved long term. In fact recent ECB comments suggest that there will be no monetary easing in Europe in the short term . Comments by Draghi such as “lending money to the IMF to buy Euro bonds is not compatible with the treaty” and emphasis that the ECB’s primary remit is price stability, indicates that talk of quantitative easing in Europe appears to be off the table in the short term. Therefore, whilst we still view the downside in gold as limited, the upside over the short term is now also looking more contained.

The U.S. economy remains timid and additional deterioration in Europe would not help their plight. Further easing in early 2012 therefore, is more than possible.

In August, the Fed promised to keep interest rates at zero for the next two years. On the back of this announcement, gold shot up 15% in a couple of weeks. With the Fed promising to keep interest rates at zero, half the equation is satisfied for real rates to stay low, at least on the short end of the curve. Further expectations of interest rate hikes (of lack of hikes) will dictate what happens at the long end of the curve, and therefore what will happen to key indicators such as the yield on 10 year TIPS.

Given such definite announcements from the Fed, the direction of real rates isn’t the difficult part of the question. The timing is. Real rates could possibly sit at their current level for a year or more, with gold correspondingly standing still. Or the U.S. economy could find itself in further strife even in the coming months and real rates could drop more in the short term. We see the second scenario the more likely of the two, but the actual outcome will lie somewhere between the two. Given the Fed’s August announcement and the U.S.’s bleak economic outlook we do not see real rates increasing any time soon.

Returning to Europe for a moment, we see no positive news coming out of this area of the world for some time. Whilst the impact of the Euro crisis on gold isn’t as direct as the impact of the U.S. economy, the secondary effect of the Euro on the U.S. and hence gold is significant. The most likely scenario is further deterioration in Europe and the global economic outlook will lead to more difficulty in the U.S. triggering further easing, lower real rates and rising gold prices.

Some are predicting the start of QE3 in early 2012, if this eventuates, one would undoubtedly see lower real rates and gold pushing the $2000/oz mark in early 2012. We see QE3 as a very real possibility and any announcement, or hint will have us opening fresh positions. The next month or so could well be the calm before the storm.

In summary, we see little downside in gold looking forward. More than likely we will see a rally in the coming months as a result of U.S. real rates dropping, but timing is the big question. Gold is currently marginally undervalued and any short term weakness will grab our attention. To find out what trades we are recommending and for more information on our options trading service, visit where you see that ur model portfolio is up 374.43% since inception in 2009.

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