By Vatsal Srivastava
As a famous market forecaster of the 1970s rightly said, in the financial markets, what is obvious is obviously wrong. The year 2014 has begun with an overwhelmingly bullish consensus towards US and European equities with the commencement of US “tapering” and the rise in US 10-year yield towards three percent representing signs of a healthy recovery of the real economy.
With the normalisation of US monetary policy and the rise in US real interest rates, the under-performance of gold is one of the most high conviction investment themes this year. However, price action in gold might not exhibit a downtrend in 2014.
The real interest rate captures the opportunity cost of holding gold relative to other risk-free assets which provide a return. Thus, historically, one of the most common reasons to have held gold was low real interest rates. The bull market of the 1970s, early 1980s and the previous decade up to 2013 were all associated with negative US real interest rates. Further, the fall in gold prices from 1982 to 2001 was associated with a prevailing period of rising and high real interest rate environment.
The poor price performance of gold during periods of high or rising real interest rates must imply a natural move of money out of gold into other asset classes as the Federal Reserve starts tapering off quantitative easing (QE) and real interest rates rise.
However, data compiled by the Bloomberg data analytics team shows this has not always been the case. From 1985 to 1987, gold prices rose even though real interest rates were also rising. The most astonishing breakdown of the relationship was during October 2003 to October 2006 when US real interest rates rose from about negative 1 percent to 3 percent, while gold gave investors a return of 60 percent over the same period.
The World Gold Council conducted a study using simple regression analysis for the time period of January 1975 to May 2013 to observe the price movements of gold under different real interest rate scenarios. The regression analysis shows that the average monthly return of gold since 1975 is 0.6 percent which roughly translates into a 7.5 percent return in annualised terms.
Although gold has performed best in times of low real interest rates — averaging about 1.5 percent monthly return — it has also provided returns in line with its long term average during a moderate real interest rate regime providing a 0.7 percent monthly return.
Thus, this evidence points towards the fact that gold will still be a store of value and provide positive risk adjusted returns close to its long-term average. Only if real interest rate were to go above four percent will gold provide monthly negative returns to an extent of one percent.
Further, when designing their portfolios, investors put a lot of emphasis on volatility of an asset. Returns alone cannot be a sole criterion to include an asset in a portfolio. Another study by the World Gold Council showed that the long-term average for gold’s volatility or standard deviation is 17.3 percent.
In a moderate real interest rate environment, gold has lower volatility than that which prevails in low and high real rate regimes. The pace of the US housing recovery is expected to cool down in 2014 and the Federal Reserve will not increase the interest rates in a hurried manner like it did in 1994 which led to a bond market crash. Thus, the US Fed taper would at best take us into a moderate real interest rate regime, with gold displaying volatility levels almost similar to its long-term average.
Incoming Federal Reserve chairman Janet Yellen is seen by many as even more dovish than her predecessor. A string of weak economic data releases on the jobs or the housing front will surely put the taper talk on the back-burner and the Fed would be forced to be more accommodative by not only returning to its original monthly buying of $85 billion of treasury bonds but perhaps even looking to increase its scale of purchases. Such a scenario could lead to a sharp reversal to the upside in the price of gold.
At around $1200/ounce, all of the medium-term bearish factors seem to have been priced into the price of the yellow metal. Huge speculative positions have been liquidated via the ETF route with the selling pressure subsidizing with gold having found support just below the $1200/ounce level. The year 2014 may not prove to be a V-shaped recovery for gold but it might certainly consolidate around these levels. The risk-reward odds seem to be stacked against the short sellers in gold from here.