The relationship between gold prices and interest rates is key to understand movements in the precious metal. Real rates capture the inflation-adjusted opportunity cost of holding gold in a portfolio. Gold does not yield any cash flows, and low rates mean that a gold holder does not lose out on much interest income. The theory goes that when rates are high, an investor will reduce gold holdings and reallocate funds to higher yielding assets, leading to lower prices for the precious metal.
The run-up in gold prices in the second half of 2020 to above $2,000/troy ounce coincided with a decrease in rates as central banks extended support to COVID-struck economies. Real rates – as measured by the Federal Reserve’s inflation indexed 5-year yields1 - bottomed out at around -2% in early 2021, where they stayed for the rest of the year. Starting in November 2021, however, real rates have been on the ascendency. In light of persistent high inflation (the U.S. recorded 7% annual inflation in 2021, the highest since 1982), some market watchers expect the Federal Reserve to raise rates aggressively starting in early 2022. This is pushing up the rates complex and dragging real yields higher. And yet, the gold price has not reacted negatively to this potential headwind. It is possible that gold bulls price in higher inflation than what the market expects (meaning lower real rates), or that the market overestimates to what extent the Fed may raise rates - again, meaning lower rates and more support for gold.
Meanwhile, geopolitical risks have certainly increased with a crisis unfolding between Russia and the Ukraine that could yet result in armed conflict in Europe. This comes on top of ongoing tensions between the U.S. and China over Taiwan as well as the threat of conflict in Korea. For many investors, the precious metal could appeal as a safe haven asset.
Originally posted on CME Group.