The Future Price of Gold and the 2% Factor (+4K Views)

[It is my contention that] the price of gold:

• rallies whenever the U.S. real short-term interest rate is below 2%,
• falls whenever the real short rate is above 2%, and
• holds steady at the equilibrium rate of 2%.

[Let me explain.]

So says Eddy Elfenbein (www.CrossingWallStreet.com) in excerpts from an article* which Lorimer Wilson, editor of www.munKNEE.com  (It’s all about Money!), has further edited ([  ]), abridged (…) and reformatted below  for the sake of clarity and brevity to ensure a fast and easy read. Please note that this paragraph must be included in any article re-posting to avoid copyright infringement.

Elfenbein goes on to say:

In this post I want to put forth a possible model for evaluating the price of gold. The purpose of the model isn’t to say where gold will go, but to look at the underlying factors that drive gold.

Gold is an Anti-currency

The key to understanding the gold market is to understand that it’s not really about gold at all. Instead, it’s about currencies and in our case that means the dollar. Gold is really the anti-currency. It serves a valuable purpose in that it keeps all the other currencies honest (or exposes their dishonesty).

Every currency has an interest rate tied to it…and, in essence, that interest rate is what the currency is all about. All those dollar bills (or euros, pounds or yens) in your wallet have an interest rate tied to it.

Gibson’s Paradox

Before I get to my model, I want to take a step back for a moment and discuss a strange paradox in economics known as Gibson’s Paradox. This is one the most puzzling topics in economics. Gibson’s Paradox is the observation that interest rates tend to follow the general price level, not the rate of inflation. That’s very strange because it seems obvious that as inflation rises, interest rates ought to keep up and as inflation falls back, rates should move back as well but, historically, that’s not the case. Instead, interest rates rose as prices rose, and rates only fell when there was deflation.

Gibson’s Paradox has totally baffled economists for years. John Maynard Keynes called it “one of the most completely established empirical facts in the whole field of quantitative economics.” Milton Friedman and Anna Schwartz said that “the Gibsonian Paradox remains an empirical phenomenon without a theoretical explanation.” In 1977, Robert Shiller and Jeremy Siegel wrote a paper on the topic. In 1988 Robert Barsky and none other than Larry Summers took on the paradox in their paper “Gibson’s Paradox and the Gold Standard,” and it’s this paper that I want to focus on…

Summers and Barsky explain that the Gibson Paradox is not connected with nominal interest rates but with real (meaning after inflation) interest rates. The catch is that the paradox only works under a gold standard. Once the gold standard is gone, the Gibson Paradox fades away.

My Model for the Price of Gold

It’s my hypothesis that Summers and Barsky are on to something and that we can use their insight to build a model for the price of gold. The key is that gold is tied to real interest rates. Where I differ from them is that I use real short-term interest rates whereas they focused on long-term rates.

Here’s how it works. I’ve done some back-testing and found that the magic number is 2% (I’m dumbing this down for ease of explanation).

• Whenever the dollar’s real short-term interest rate is below 2%, gold rallies.
• Whenever the real short rate is above 2%, the price of gold falls.
• Gold holds steady at the equilibrium rate of 2%.

It’s my contention that that was what the Gibson Paradox was all about since the price of gold was tied to the general price level.

Now here’s the kicker, there’s a lot of volatility in this relationship. According to my backtest, for every one percentage point real rates differ from 2%, gold moves by eight times that amount per year. So if the real rates are at 1%, gold will move up at an 8% annualized rate. If real rates are at 0%, then gold will move up at a 16% rate (that’s been about the story for the past decade). Conversely, if the real rate jumps to 3%, then gold will drop at an 8% rate.

In my view, there are a few key takeaways, namely:

1. gold is tied to low real interest rates which are often the by-product of inflation. Right now we have rising gold and low inflation. This isn’t a contradiction.
2. when real rates are low, the price of gold can rise very, very rapidly.
3. when real rates are high, gold can fall very, very quickly.
4. there is no relationship between equity prices and gold (like the Dow-to-gold ratio).
5. the TIPs yield curve indicates that low real rates may last for a few more years.
6. the price of gold is essentially political. If a central banker has the will to raise real rates as Volcker did 30 years ago, then the price of gold can be crushed.

Conclusion

In effect, gold acts like a highly leveraged short position on U.S. Treasury bills and the breakeven point is 2%.

*www.crossingwallstreet.com/archives/2010/10/a-model-to-explain-the-price-of-gold.html

 Scroll to very bottom of page & add your comments on this article. We want to share what you have to say!

Editor’s Note: The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.