How gold prices are linked to real yields of Treasuries…

Nicholas J. Johnson of PIMCO has this useful piece on figuring Gold prices.

We usually say that when Treasuries become risky people buy gold and vice-versa. So there is an inverse relationship between treasury yields and gold prices.

His analysis looks at this relationship closely:

What is it about gold prices? Many people seem to believe they are impossible to predict, or even understand. At her Senate confirmation hearing in November, Janet Yellen said, “I don’t think anybody has a very good model of what makes gold prices go up or down.” Ben Bernanke also said last year that “nobody really understands gold prices, and I don’t pretend to understand them either.” While many factors influence the price of gold, PIMCO believes there is one that can explain the majority of changes in gold prices over the past several years: changes in real yields.

To understand how, it helps to start with a simple example. Pretend there was an asset that had no risk of default and a real – that is, inflation-adjusted – value that varied over time but did so around some constant level. In other words, this asset has no credit risk and in the long run maintains its purchasing power. How much would investors pay for it? Whatever the amount is, it would likely vary over time with the level of real yields available in very high quality, nearly “default-free” assets (such as U.S. Treasuries). That is, when real yields on other such assets are high, investors would likely want a bigger discount to the long-run estimated real value of the hypothetical asset. Conversely, when real yields are low, the opportunity cost of owning the asset drops and investors would likely be willing to pay a higher price relative to the asset’s long-run estimated real value.

In essence, this guides how PIMCO thinks of gold. And the market seems to view gold this way as well; over the past several years, gold prices have been heavily influenced by the level of 10-year U.S. real yields (see Figure 1).

Be careful of Figure 1. The axis has been inverted, You might (atleast I did initially) think it is +ly related but is -ly related..

To quantify the relationship between real gold prices and real yields, we can regress the price of gold from 2006 to 2013 (we used the logarithm of the real price of gold in our model) against the 10-year real yield from the Treasury Inflation-Protected Securities (TIPS) market. (In our view, this regression is appropriate since gold and real yields are co-integrated and there is an economic rationale for believing they should be.) Based on our study, the regression shows that, all else equal, a 100-basis-point (bp) increase in 10-year real yields has historically led to a decline of 26.8% in the inflation-adjusted price of gold. In other words, over the past seven years gold has had a real duration of 26.8 years. (Note that this is solely an empirical duration that describes the way that gold has traded. Since gold has no cash flows, its duration does not need to be constant, and there is nothing magic about the 26.8 number. Just as the correlation between stocks and bonds varies over time depending on changes in macroeconomic variables and investor risk appetite, the real duration of gold may also change in the future.)

Using this framework, consider the 15% price drop in gold in mid-April following talk of Fed tapering. This move predated the sharp move higher in yields in the fixed income market by two weeks. Over the month of May, 10-year real yields rose 57 bps. Even though the markets moved at different times, the size of their moves over this period was remarkably consistent with the historically observed 27-year real duration. In hindsight, we believe the move in gold gave an excellent early warning of both the direction and magnitude of the move in rates.

Nice bit…Commonly and loosely market thought on gold and bonds is being validated with econometrics..

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.


%d bloggers like this: