Interest rate movements have made their mark on gold prices over the past two years.
After a strong 2020 performance where the price rallied 25% in US dollar terms in an environment where rates fell, gold has been much weaker during 2021, down 5% year-to-date with rising rates.1 While demand for gold has rebounded, particularly in the jewellery and bar and coin markets,2 the recent gold price sell-off has been largely driven by the sharp increase in interest rates in global fixed income markets relative to the record lows they reached last year (Chart 1).3
Rate increases have been driven by improving economic conditions and higher inflation expectations. While in the short-run, higher rates are a headwind for gold, we believe that gold remains a key strategic portfolio component for several reasons:
- A rising rate environment does not always result in gold’s price underperformance (p. 1-2)
- A significant increase in inflation and/or money supply may offset the negative effect from rising rates (p. 2)
- Central banks may use alternative monetary policy tools to limit the negative effect of rising rates (p. 3)
- The prolonged level of short-term interest rates is creating a structural shift in asset allocation strategies by reducing expected returns and/or increasing portfolio risk (pp. 5-6).
Chart 1: Gold's performance since the COVID-19 equity selloff has been dominated by rates
Gold's performance since the COVID-19 equity selloff has been dominated by rates
Gold price and the inverted US 10-year yield*
Gold's performance since the COVID-19 equity selloff has been dominated by rates
Gold price and the inverted US 10-year yield*
*19 February 2020 to 31 March 2021. Based on LBMA Gold Price PM USD and Bloomberg’s US Government Generic 10-year Yield Index.
Source: Bloomberg, World Gold Council
*19 February 2020 to 31 March 2021.
Based on LBMA Gold Price PM USD and Bloomberg’s US Government Generic 10-year Yield Index.
Higher rates are a short-term headwind for gold
One of the four key drivers of gold performance relates to the opportunity cost of holding it.4 High coupons – or, alternatively, large dividends – can make gold less attractive, especially for investors who require steady income streams. But the reason gold does not pay a direct ‘yield’ is because it does not have counterparty risk, and therefore represents no-one’s liability.
As rates have fallen over the last several years, the investment case for gold has become stronger. And despite the recent rise in yields, many nominal rates are negative and all sovereign debt in developed nations is effectively negative in real terms.5
As nominal yields have come down in recent decades, the correlation between gold return and the change in interest rate yields has mostly turned more negative (Chart 2).6 Similarly, as equity dividend yields have fallen amid lofty valuation, gold prices have generally rallied.
Chart 2: Correlation of gold to US Treasury yields has plummeted over time, but recently ticked higher
Correlation of gold to US Treasury yields has plummeted over time, but recently ticked higher
Trailing 3-year correlation of gold to 10-year US Treasuries*
Correlation of gold to US Treasury yields has plummeted over time, but recently ticked higher
Trailing 3-year correlation of gold to 10-year US Treasuries*
*1 December 1973 to 31 March 2021. Based on LBMA Gold Price PM USD, Bloomberg’s US Government Generic 10-year Yield Index, and S&P 500 Index dividend yield.
Source: Bloomberg, World Gold Council
*1 December 1973 to 31 March 2021. Based on LBMA Gold Price PM USD, Bloomberg’s US Government Generic 10-year Yield Index, and S&P 500 Index dividend yield.
Chart 3: Gold's sensitivity to interest rates is near record highs
Gold's sensitivity to interest rates is near record highs
Trailing 2-year gold betas*
Gold's sensitivity to interest rates is near record highs
Trailing 2-year gold betas*
*1 December 2002 to 31 March 2021.
Note: DM FX: comprises euro and yen dollar pairs. Based on LBMA Gold Price PM USD, Bloomberg US Government Generic 10-year Yield Index, and US 10-year Breakeven Inflation Index.
Source: Bloomberg, World Gold Council
*1 December 2002 to 31 March 2021.
Note: DM FX: comprises euro and yen dollar pairs. Based on LBMA Gold Price PM USD, Bloomberg US Government Generic 10-year Yield Index, and US 10-year Breakeven Inflation Index.
The strong relationship gold has exhibited to both interest rates and currency value is not a recent phenomenon. Analysis from our short-term gold return model shows that since 2000 gold has exhibited a consistently negative correlation to currency purchasing power particularly in developed markets.7 In addition, its sensitivity to interest rates was also higher during periods marked by heightened inflation expectations, like 2008, 2012, and 2020 (Chart 3). This is explained by increased attention of the market to actions or forward guidance given by the US Federal Reserve (Fed) and other central banks.
Normalised (higher) rates aren’t necessarily debilitating for gold prices
While rates recently moved sharply higher, they remain historically low and are, in real terms, mostly negative across developed markets. Our analysis suggests that US real rates would need to move above 2.5% for there to be a meaningful long-term negative impact on gold (Table 1). While real rates are currently below zero, a return to a real rate environment of 0–2.5% would likely impact gold, but only to the extent of it realising slightly below its long-term average real return of 6.1%.8 Rising rates certainly provide more headwinds to gold than falling rates, but gold can still provide positive real returns in a rising rate environment. Historically, it required an interest rate environment over 2.5% in real terms to have a significant negative impact on gold prices. Considering that recent interest rate changes have only come on the heels of higher inflation, it remains likely that any normalisation in interest rates would predominantly be by just a nominal measure. Moreover, since the mid-1990s Fed inflation policy revolving around an approximate 2% target has largely mitigated the risk of a significant run-up in nominal yields, particularly when starting from a low base as is the case today.
Table 1: Gold has outperformed its long-term average in moderate real- and nominal-rate environments
Average gold return in varying interest rate environments*
*31 January 1970 to 31 March 202. Interest rate environments classified by US 10-year interest rate yield.
Source: Bloomberg, World Gold Council
An increase in rates, is likely to be a by-product of inflation, which may be positive for gold
A sustained increase in interest rates beyond the aforementioned thresholds may materialise if there were to be a shift in inflation dynamics not seen in decades.9 Such an event would trigger meaningful changes to interest rates, with an increased opportunity cost to holding riskier assets such as stocks. As risk assets sell off, gold’s value as a contributor to portfolio return comes into focus, particularly several months into the inflation cycle.
‘Reflation’ periods such as we are seeing today, marked by resurgent economic growth alongside rising inflation and interest rates, have seen other major commodities outperform gold in the first six months. However, on average since 1991 gold has caught up and in fact, outperformed other sectors and commodities by the second and third years (Chart 4).10
Examining this 30-year trend proves helpful as it is likely to be more indicative of the current policy environment in which central banks have kept real rates relatively anchored. As a result, even given an uncertain inflation picture down the road, this return profile supports the use of gold in at least a medium-term inflation hedge strategy.
Chart 4: Gold outperforms other commodities later in a reflation period
Gold outperforms other commodities later in a reflation period
S&P GSCI Commodity Total Return Indices and spot US$ gold performance before and after US recessions*
Gold outperforms other commodities later in a reflation period
S&P GSCI Commodity Total Return Indices and spot US$ gold performance before and after US recessions*
*1 March 1988 to 29 February 2020. Each dot in the chart represents the annualised return for a series. The large dots show performance after the reflation period began and the small dots show the performance prior. Each dot also shows the high and low ranges of returns. All series are S&P GSCI Total Return series except for spot US$ gold.
Source: Bloomberg, World Gold Council
*1 March 1988 to 29 February 2020. Each dot in the chart represents the annualised return for a series. The large dots show performance after the reflation period began and the small dots show the performance prior. Each dot also shows the high and low ranges of returns. All series are S&P GSCI Total Return series except for spot US$ gold.
Monetary policy has become an increasingly important driver of gold prices
In the preceding period prior to the Global Financial Crisis, monetary policy did not reign over financial markets, including gold, to the extent we see it does today. With less attention on central banks, gold prices were arguably more impacted by movements of the dollar directly. Since the initial Quantitative Easing (QE) implementation, gold prices have been supported by easy money and expanding balance sheets, both of which hurt the purchasing power of fiat currency. This relationship strengthened again during the onset of the COVID-19 pandemic, as the consequent monetary easing and fiscal spending kicked off another period with immense balance sheets and zero-bound interest rates, and pushed gold prices higher. In recent months, gold has trailed lower with interest rate yields rising alongside inflation expectations, even as policy support has remained unchanged.
With ballooning debt burdens relative to GDP, and with a commitment to keep rates low, policymakers may be forced to act on the long end of the rates curve to ensure expectations remain anchored (Focus 1) but could do so at the expense of further expanding their debt (Chart 5).
Chart 5: Balance sheet sizes may pose risk for central banks to hike interest rates
Balance sheet sizes may pose risk for central banks to hike interest rates
G4 and Fed balance sheet as a % of GDP*
Balance sheet sizes may pose risk for central banks to hike interest rates
G4 and Fed balance sheet as a % of GDP*
*1 January 1999 to 29 February 2021.
*G4 refers to the US Federal Reserve, European Central Bank, Bank of Japan, and Bank of England.
Source: Bloomberg, World Gold Council
*1 January 1999 to 29 February 2021.
*G4 refers to the US Federal Reserve, European Central Bank, Bank of Japan and Bank of England.
Focus 1: Central banks have begun yield curve control (YCC)
Even as rates have continued to move higher this year, central banks’ commitment to accommodative monetary policy has stood firm. This has presented a widening trend between short- and long-term interest rates, marked by investors with elevated inflation expectations on the one hand, and policymakers with near-term focus on economic recovery in the labour market on the other. However, central banks can still play a role in containing some of these longer-run rates expectations as well – most recently witnessed in Australia.
As a significant commodity exporter, particularly of metals,11 Australia has been notably impacted by the surge in resource prices year-to-date. The relationship between commodity prices and economic variables in the country is so prevalent that the Australian dollar is considered a commodity currency.
Elevated inflation expectations driven by soaring resource prices led to a significant steepening of the yield curve,12 with a rise in medium- and long-term rates of 50–100 basis points since the start of the easing cycle in March 2020 (Chart 6). In response to this, in February 2021 the Reserve Bank of Australia (RBA) enacted a form of yield curve control (YCC) to help slow rising rates across the curve.
Chart 6: Australian long-term yields rose in months prior to yield curve control
The RBA announced that in addition to reaffirming its intent to keep the current policy rate steady until 2024, it would commit to a 3-year yield target of 0.10% to keep borrowing costs low for the foreseeable future. Since this time, as the front end of the Australian Sovereign Curve remained anchored, the ‘belly’ (medium-term) and long end shifted down in anticipation of further central bank accommodation and yield curve control (Chart 7).
Chart 7: Australian rate outlook has turned dovish since implementing yield curve control
Another Operation Twist?
While Australia has controlled the shorter end of the curve, this could set the tone for another Operation Twist,13 or similar initiative, in the US, focusing on long-term interest rates as the yield curve continues to steepen. Enacted both in the early 1960s and 2011, this maturity extension programme of Fed assets served to continue monetary easing while avoiding the inflationary impact of further expanding its balance sheet or increasing the money supply, by putting downward pressure on longer-term interest rates -- a policy the Reserve Bank of India similarly initiated in December 2019 by flattening the yield curve to lower term premia.14 Additionally, there have also been discussions around adding longer-dated bonds, with 50- or even 100-year maturities, enabling further YCC.15
Lower rates have made bonds smaller components of portfolio performance
The traditional 60/40 portfolio (60% equities, 40% bonds) has become less prominent as investors have gained access to additional fixed income and alternative assets.16 However, breaking down the attribution of fixed income securities within the portfolio helps illustrate what has driven returns over the past few decades. Namely, due to rates movements being lower over the past several years, the analysis shows how optimal portfolios would have benefitted from larger gold allocations.
When isolating the fixed income side of the US market, we consider Treasuries, long-term Treasuries, corporate bonds, bond aggregates and high yield bonds, calculating each one’s attribution to historical returns. It has become clear that higher quality fixed income returns have fallen significantly below levels of lower quality or longer duration ones (Chart 8). At a sub-asset class level this is also illustrated in declining US Treasury returns over the full period of the analysis (Chart 9).
When considering the long-term average of the Bloomberg Barclays US Bond Aggregate Index -- often a proxy for the overall bond market -- one can see that on a 10yr rolling basis it has returned 5.6% on average over the past 20 years. However, these returns have fallen in a lower rate environment since the first QE. If we were to optimise returns for the five fixed income securities, by constraining returns to a minimum of the historical average of 5.6% while minimizing portfolio volatility, we see that portfolio volatility increases, and the allocation to assets further out on the credit curve, particularly high yield, also increases (Chart 10).
Larger allocations to those securities increases the portfolio volatility of the optimised portfolio, which had been below the US Bond Aggregate portfolio up until the Global Financial Crisis, and, of course, the weights of higher volatility assets increased as well (Chart 11).
Chart 8: Treasury and corporate bond returns have fallen below long-term averages, prompting shifts to riskier fixed income assets
Treasury and corporate bond returns have fallen below long-term averages, prompting shifts to riskier fixed income assets
Average 10-year returns using rolling monthly data*
Treasury and corporate bond returns have fallen below long-term averages, prompting shifts to riskier fixed income assets
Average 10-year returns using rolling monthly data*
*Based on 10-year rolling monthly returns from January 2000 to December 2020.
Source: Bloomberg, World Gold Council
*Based on 10-year rolling monthly returns from January 2000 to December 2020.
Chart 9: Declining Treasury returns mark the diminished role of high-quality fixed income in portfolios
Declining Treasury returns mark the diminished role of high-quality fixed income in portfolios
Annual 10-year US Treasury returns*
Declining Treasury returns mark the diminished role of high-quality fixed income in portfolios
Annual 10-year US Treasury returns*
*As of December 2020
Source: Bloomberg, World Gold Council
Chart 10: Optimised bond portfolios have shifted from lower volatility to higher volatility levels against the broad fixed income space as high yield weights have increased
Chart 10: Optimised bond portfolios have shifted from lower volatility to higher volatility levels against the broad fixed income space as high yield weights have increased
Difference of portfolio standard deviations of bond aggregate portfolio vs. optimised fixed income portfolio against the high yield weights*
Chart 10: Optimised bond portfolios have shifted from lower volatility to higher volatility levels against the broad fixed income space as high yield weights have increased
Difference of portfolio standard deviations of bond aggregate portfolio vs. optimised fixed income portfolio against the high yield weights*
*Based on 10-year rolling monthly returns from January 2000 to December 2020.
Source: Bloomberg, World Gold Counci
*Based on 10-year rolling monthly returns from January 2000 to December 2020.
Chart 11: Shifts to high yield and long-term treasuries have increased volatility and duration risk
Shifts to high yield and long-term treasuries have increased volatility and duration risk
Rolling 10-year annual volatility*
Shifts to high yield and long-term treasuries have increased volatility and duration risk
Rolling 10-year annual volatility*
*1 January 2000 to 31 March 2021.
Source: Bloomberg, World Gold Council
*1 January 2000 to 31 March 2021.
#footnote-4
Market return expectations are low
Many market experts suggest the return assumptions for most fixed income securities will average between 2% and 4% over the next decade, with equity return expectations in the single digits as well.17 Many pensions and endowments have liability assumption returns of 6%-8%19 and given these lower asset return expectations investors may need to have larger weights to alternative assets or increase leverage. Recent data from Willis Towers Watson also suggests increases in alternative investments, and our research indicates that as portfolio risk, i.e. volatility increases, the optimal allocation to gold also increases to the higher end of the 2--10% optimal allocation our model has suggested.20
We also consider the current and expected market environment and look to optimise portfolios based on those expectations. We utilised the 20-year total return performance of the aforementioned fixed income securities along with the S&P 500 and gold.
When adjusting fixed income market assumptions lower, it significantly lowers the expected return, and without leverage or additional allocations to other assets like alternatives, it could be very difficult to achieve portfolio assumption levels of 6--8%, while even reducing expected future gold returns to 5% (less than half of its historical average of 10%), it improves the risk adjusted returns of the low-rate portfolio. And if we analyse an optimised portfolio with historical gold returns, matched with expected bond returns, the portfolio is able to achieve the 6--8% expected return without significantly increasing portfolio volatility or leverage.
Conclusion
Even though rates have ticked higher in recent months, they remain historically well below long-term levels and levels that should negatively impact gold returns. Absent a true increase in inflation, which has historically been good for gold, we do not expect rates to increase meaningfully without central bank intervention. We have seen that traditional bond allocations contribute much less to portfolio returns which has forced many investors to take additional risk with lower credit fixed income investments and other alternatives that increase portfolio risk. All of these factors continue to strengthen the rationale for a strategic allocation to gold in portfolios.
Footnotes
Based on the LBMA Gold Price PM as of 19 April 2021.
India’s gold market in February: Indian imports hit a 21-month high amid robust retail demand, 18 March 2021 and China’s gold market in February: local gold price premium rose further as gold consumption improved, 10 March 2021.
Gold is moving with rates, 25 February 2021.
The relevance of gold as a strategic asset, 16 February 2021.
As of 31 March 2021, for G7 countries. See: Investment Update: It may be time to replace bonds with gold, 30 October 2019.
Gold Market Commentary: Rates continue to dominate, 8 April 2021
Based on weekly inputs to World Gold Council’s short-term gold price driver’s model.
Based on the US 10-year Treasury Inflation-Protected Securities (TIPS) yield
See Investment Update: Gold as an inflation hedge, short and long-run considerations
Gold, commodities and reflation, 2021 March 26, World Gold Council.
Based on “Trade and Investment at a Glance – 2019” report by Australian Government: Department of Foreign Affairs and Trade.
See The low-return environment in Australia and gold’s role, 24 March 2021.
“Maturity Extension Program and Reinvestment Policy” by the Federal Reserve, 2 August 2013
“Inside India’s Twist of the Yield Curve”, 31 December 2019
“Yellen Gets Wall Street Buzzing About 50-Year U.S. Treasuries”, 19 January 2021
“The 60/40 Model is Dead, What to Do?”, 4 March 2020, and The 60/40 Portfolio Review and ETF Pie for M1 Finance.
We utilised the 2021 J.P.Morgan Asset Management Long-Term Capital Market Assumptions as a guide for expected market returns and volatility over the next 10 – 15 years. https://am.jpmorgan.com/content/dam/jpm-am-aem/global/en/insights/portfolio-insights/ltcma/ltcma-full-report.pdf
Pension Funds Adjust Investment Return Targets as Economic Growth Slows. 2020 January 8.
Willis Towers Watson, Global Pension Assets Study 2021, February 2021 and Global Alternatives Survey 2017, July 2017.
See footnote 4 on page 1.
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