The going looks good for gold

Is gold set to hit fresh records? Citigroup’s analysts this week said “it is only a matter of time” before the yellow metal surpasses its 2011 dollar high of just over $1,920 an ounce. The investment bank also reckons there’s a 30% chance that gold will go above the $2,000 mark within the next five months. Yet gold is already at, or near, all-time highs in almost any currency you care to mention. Given all this, you might be wondering (particularly as a sterling investor): can gold really go much higher from here?

To answer that, we need to look at what drives the gold price. Many investors think that gold is an inflation hedge, but that’s not the whole story. What really drives gold is movements in “real” interest rates (ie, interest rates after inflation – defined in more detail below). In short, falling real rates are good news for gold. Gold carries no credit risk (a gold bar can’t go bankrupt); it has a long-term history of retaining its value through a range of economic backdrops; and when the yield on other assets is falling, or even negative, the 0% yield on gold doesn’t seem so bad. So today’s environment of growing concern about inflation, plus near-0%, or even negative, nominal interest rates, looks good for gold.

But will real rates keep falling?

Governments are taking on a great deal of debt to contend with the impact of the coronavirus lockdown. While some expect central banks to raise rates if inflation appears (see page 20), this seems a stretch. Even a small increase in rates would render this debt unpayable. The reality is that governments need rates to remain below inflation in order to erode away its value. Indeed, as Tim Duy notes on Bloomberg, the US central bank, the Federal Reserve, may be on the verge of officially taking a more relaxed approach to its 2% inflation target. This is called “financial repression” and it’s by no means a new tool. So assuming that inflation does rise – which again seems likely given the sheer scale of public spending – then real interest rates may well continue to fall.

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Markets don’t move in straight lines and all the fresh attention paid to precious metals (this week’s surge in silver has been particularly eye-catching) may indicate a short-term top. But the backdrop remains promising. You can buy physical gold from a bullion dealer, or get exposure using one of the many exchange-traded funds (ETFs) available, such as Royal Mint Physical Gold (LSE: RMAU). If you’d like to bet on silver – which tends to outperform once a gold bull market gets going – then consider a silver ETF such as WisdomTree Physical Silver (LSE: PHAG), but bear in mind that silver is far more volatile.

I wish I knew what a real interest rate was, but I’m too embarrassed to ask

A “real” interest rate is simply an interest rate that has been adjusted to take inflation into account. (A “nominal” interest rate is one that has not been adjusted for inflation). This matters because inflation reduces the value of any future stream of income.

Take a bank account into which you plan to place £1,000. If inflation is running at 1% then a 2% nominal interest rate looks quite respectable – your savings will have more purchasing power a year from now. However, if inflation is running at 3%, your savings will have less purchasing power when you withdraw them in a year’s time, even though the £1,000 will have grown (in nominal terms) to £1,020. Of course, the advertised rate will be the nominal one, not the real one.

The real interest rate is given by the Fisher equation (named after US economist Irving Fisher, who refined the calculation). However, while this gives a more precise answer, for most purposes it’s much easier to simply subtract the inflation rate (which can either be current or expected) from the nominal interest rate. So in the first example above, the real interest rate is 1% (you are earning a “real” return of 1% a year), whereas in the second example it’s minus 1% (you are losing money in real terms).

One way to get an idea of market expectations for inflation is to compare yields on index-linked government bonds (which enjoy inflation protection) to normal government bonds. In the US, for example, taking the difference between the yield on Treasury Inflation-Protected Securities (Tips) and the yield on standard Treasuries of a similar maturity gives the “break-even” rate – the level of inflation that means an ordinary Treasury will return the same as an index-linked one. Using this measure, notes Sam Goldfarb in The Wall Street Journal, inflation expectations have risen sharply since May, even as yields on both Treasuries and Tips have fallen, implying that rates will remain low.