Monday, Aug 15, 2022

The Curious Case Of Falling Gold Prices

Look at prices of precious metals in relation with real rates of return, other commodities and new players like cryptocurrencies.

Indians are known globally for their penchant for gold. Connoisseurs of the yellow metal keep track of every price move and use every dip as a buying opportunity. But very few Indians know why and when gold prices move up or down. It is a common belief that gold is insurance against inflation and its price moves up when inflation inches up. But is it so?

In 2021, inflation has been moving up, but contrary to common understanding, gold prices have been falling. Adding insult to injury is that other commodities like iron ore, crude oil, natural gas etc. moved up and yielded good returns for investors. Precious metals' prices remained soft, especially for gold and silver. Why?

To understand the price movement dynamics, we need to understand certain features of gold. First and foremost, investors should understand that gold is an unproductive and non-yielding asset whereas stocks and bonds pay dividends and interest. Therefore, investors should always keep in mind that gold investments are always relative to how other asset classes are behaving.

“Gold neither pays interest nor pays dividend so till the time corporate profitability is expanding and bonds pay positive real rates, you don’t need gold,” says Ritesh Jain, a Canada-based global macro investor.

Year to date, the Nifty index has given over 28 per cent returns while gold returns are in negative, though in the Indian currency, gold has given positive returns every year since 2000 except for calendar years 2015 and 2013 (see table).

The other important feature of gold is how it behaves in relation to real interest rates (nominal interest rates minus inflation). And in this mathematical expression lies the answer to the puzzle of inflation’s correlation with gold prices.

Investors should always keep in mind that if inflation moves up but nominal rates to move up accordingly, then real rates would remain flat and gold prices would not increase.    

Speaking with Outlook Money, Rich Excell, Instructor of Finance, the University of Illinois at Urbana-Champaign, says gold reacts inversely to real interest rates. “There is a negative correlation between gold and real interest rates, so negative or lower real rates should move the price of gold higher, and conversely, higher real rates should take gold prices lower,” Excell explains.

Between November 2018 and August 2020, gold prices increased by over 70 per cent as long-term US real yields collapsed from 1.2 per cent to (-)1.1 per cent. But after that, there was a rise in real yields as nominal yields (10-year treasury) moved up much faster than inflation, which explains gold’s lacklustre performance in 2021. But in the past few months, inflation has again started moving up as compared to nominal yields. So, gold prices may move up significantly, believes Jain.

“According to our proprietary model, which tracks equity-gold ratio, the yellow metal is looking more attractive than equities for the next five years,” he says.

Commodities’ Carry Costs

Most investors are not aware that commodities and precious metals are not priced as a single data point like a stock. There are futures contracts for each month heading out many years in the future. For a non-perishable commodity like gold or crude oil, there is a ‘cost of carry’, which is a combination of funding, storage and insurance costs.

The ‘carry cost’ for gold is primarily funding cost as storage cost is low. But for oil and other commodities, storage and transportation costs are high. In normal times, the spot price of these commodities is lower than future prices (also called Contango in commodity trading parlance).

Commodities like gold and silver that have lower carry costs have not performed well in 2021 while commodities with high carry costs have surged. Natural gas, for instance, has doubled within a year. One reason that can explain this anomaly is a supply shock. Essential commodities like oil and natural gas have huge demand due to their utility function but gold’s utility is limited, mostly as ornaments. So, while buying gold and silver, investors need to understand the demand and supply ecosystem for other commodities as well along with their utility functions.

Crypto Pull

Interestingly, the most important factor that has recently started impacting gold prices is the rise of cryptocurrency. Within 12 years, Bitcoin, the first cryptocurrency, achieved a market cap of $1 trillion. Investors are now pouring money into cryptocurrencies rather than gold.

“Cryptocurrencies move in reaction to fiscal largesse and monetary debasement and are not weighed down by real rates because there is no carrying cost involved as is the case with the gold,” says Excell.