Why should gold shine?


In most investors’ mind, gold and precious metals provide a natural protection in periods of market turbulence and falling share prices. This is generally true but the devil is always hidden in the details. One should understand what drives the market price of gold and what is the underlying risk.

What drives the price of gold

a) The level and direction (trend) of real interest rates:

Real interest rates are calculated by subtracting the inflation rate from nominal interest rates.

real rate = nominal rate – inflation rate

The lower the real interest rate the higher the price of gold.

This relationship is further magnified in periods where real interest rates are negative as investors would prefer gold to maintain their wealth. In periods where real interest rates are high gold becomes an expensive asset to hold as it bears storage costs and offers zero yield.

b) Supply-demand balance: The supply-demand balance is among other important factors, though more difficult to monitor and measure. For example, central bank sales of gold exacerbated the 1999 gold price slump.

Lessons from the past

In the second half of the 70s both interest rates and inflation rates were high. Inflation however exceeded the nominal returns on bonds, therefore real interest rates have been negative. As a result, investors shifted their capital into gold. As soon as Paul Volcker hiked nominal interest rates and real rates came back into positive territory the gold boom ended.

In late 2007 and the years after, real rates had been negative as a result of the Fed actions to stimulate the economy keeping nominal rates at record low. The gold price increased again.

In the graph below we present this relationship.

Source: FRED, KM Cube

Today’s environment

Following the Covid-19 pandemic, central banks across the world have significantly decreased interest rates pushing real interest rates into negative territory again.

Printing money to stimulate the economy, increases the risk of inflation which further puts pressure on real interest rates.

Such an environment is positive for gold and potentially justifies further appreciation.