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Investment Uncovered: The Trump effect on gold

Gold-700x450.jpgGold prices historically have maintained a tight, inverse relationship with real yields on 10-year US Treasuries, but this relationship has weakened in the past year, suggesting the precious metal’s price is now being driven by other forces.

Real yields are adjusted for inflation, so the real yield on 10-year US Treasuries, for example, is the nominal yield minus the headline rate of inflation (see chart 1).

In times of high inflation, the coupons, dividends or interest payments from fixed income instruments fall in real terms and investors typically look elsewhere.

The effect in the fixed income markets is that nominal bond yields are pushed higher as investors demand a higher return to make up for the drop in their purchasing power. This should reduce the need for gold as an inflation hedge and yet its price has continued to advance since the start of 2017.

Another traditional headwind for gold has been rising interest rates. If inflation increases too quickly or above the central bank’s target rate, interest rates are likely to be raised, causing households to borrow less from banks and giving them an incentive to reduce expenditures and put their money away for the future. This should, in theory, work to reduce inflation.

When interest rates rise to counteract inflation, gold becomes less attractive. The easier option of holding money in fixed income assets, or even in a cash account earning the higher rate of interest, seems preferable to the risk and costs associated with purchasing and storing the physical commodity.

After years of ultra-loose monetary policy, the US Federal Reserve is now in the process of normalising interest rates in the US, which should dampen the return from gold.

However, despite both fixed income yields rising and interest rates gradually climbing, gold prices have risen 3.6 per cent this year to date. So what is behind the increase?

Firstly, commodities are typically priced in US dollars, which means that gold has an inverse relationship with the US dollar (see chart 2). This is because a fall in the value of the dollar increases the purchasing power of foreign currencies in terms of dollar-denominated assets, thereby raising the demand for gold.

As well as this, gold acts as an inflation hedge, meaning that when the value of the US dollar declines investors often look for alternative investments such as gold to protect their funds.

Gold is seen both as a safe haven asset and as a way to hedge against inflation. A safe haven asset is one which will protect capital in times of market stress, while a hedge protects against a particular negative outcome for example, higher than expected inflation, which eats away at investors’ real return.

Normalising interest rates in the US should dampen the return from gold, but prices have risen 3.6 per cent this year

As a safe haven asset, the precious metal will also perform relatively well in times of heightened geopolitical tension.

If uncertainty in the US and Middle East continues to mount and US relations with Russia and North Korea continue to deteriorate, the case for gold should strengthen.

The price of gold jumped 0.8 per cent on 11 April this year, rising to $1,351 (£1,000) per ounce following President Trump’s tweet regarding Syria and the “nice and new smart missiles” which would soon be heading their way.

As gold is not often used in an industrial way, it has fewer supply and demand constraints than other metals. As a result, the price should be less volatile, making it a safer bet than other commodities.

In summary, it seems the price of gold is now being driven by geopolitical tension and the US dollar rather than real Treasury yields.

As inflation increases the US dollar could strengthen, but the return of inflationary pressures is also good for gold.

The precious metal is currently trading in a narrow range. But with Trump continuing to threaten tough trade sanctions against China and offend most of the developed and developing world, combined with an uncertain future relationship between the UK and Europe, gold should at least remain on a solid footing with potential room for its price to rise further.

Sophie Meatyard is fund analyst at FE

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