Gold and Real Interest Rates. Fact, Fiction, or a Half-truth?

August 17 2015

In many gold-related articles, the term real interest rate is often used; or in other words, the nominal interest rate corrected for inflation. It is often said that low real rates are favorable for the gold price, while high real interest rates are unfavorable. This is often supported with multiple graphs, correlations, and sometimes even statistical models. But does it make sense theoretically? As we investigate, we will see that it is a half-truth. Low real interest rates create the conditions that could lead to an upward trend in the gold price, however it is not certain. The role that gold can play for an investor depends completely on the type of investor he or she is. 

The Alleged Relation Between Real Interest Rates and Gold

The real interest rate is the nominal interest rate, minus a correction for inflation.

If your savings account paid 1% interest on your savings, but if inflation is at 2%, then your capital will lose 1% of its purchasing power. Or in other words, you would have earned a negative real interest rate of 1%.

In gold-related articles, the prevailing theory states that low real interest rates make saving unattractive, and that investors are therefore pushed towards alternatives — among those alternatives is gold

Sometimes it is mentioned that negative real interest rates would discourage saving and investing, thereby hurting the economy, which would then again be favorable for gold.

These claims are supported with graphs, correlations and models. However it doesn’t give us a straight answer; there is much statistical evidence for as well as against the claim that low real interest rates and a higher gold price go hand in hand. Or at least it doesn’t always seem to hold.

The absence of a strong statistical relationship doesn’t immediately have to mean that the alleged theory is incorrect though. While you would expect the gold price to rise during periods with low real interest rates, this may be counterbalanced by factors simultaneously pushing the gold price down.

The only way to approach this is to critically look at the argument from a theoretical standpoint. Let’s begin with two problematic aspects of the theory, before moving on to the elements of truth contained in it.

Problem #1: The Real Interest Rate Cannot Be Measured Objectively

We cannot say with certainty what the real interest rate is. The correction for inflation to be applied is something we cannot objectively measure.

If you’re wondering what the temperature is, you could take a look at a thermostat and thereby get a definitive answer.

Often, as it is in the Netherlands, inflation is reported to two decimal places. However, in no way does this constitute an objectively measured fact.

The euro’s purchasing power resembles what someone could buy with one euro. And in a modern economy, that is quite a lot; millions of different products, with continuously fluctuating quality.

Take the consumer price index (CPI), which measures price level changes by using a basket of consumer goods. The product choices, weights and corrections that is used are all choices that could’ve been made different. However, this doesn’t mean that the CPI is a bad measure, considering that there is no objective measure for inflation.

Regardless of how badly we want certainty, the occasional differences between the inflation that we subjectively experience and the 'official' rate, illustrate that this 'measure' does not give a definitive answer.

The uncertainty of real interest rate levels make us wonder to what extent investors can actually make decisions on the basis of a magnitude — the real interest rate — the level of which nobody even knows for sure.

It also raises another question; to what extent is it a statistical illusion? How are we sure that in a certain period of time, real interest rates were negative, rather than overly high 'measured' levels of inflation being applied?

Problem #2: Low Real Interest Rates Do Not Discourage Saving

The biggest problem with the assertion that low real interest rates lead to higher gold prices by discouraging saving, is that low real interest rates do not discourage saving at all!

Just imagine, your capital of 1 million is on a savings account yielding 5% interest. If inflation is at 1%, the real interest rate you earn is 4%. Inflation now rises to 3%, which means your real interest rate drops to 2%. Will you start saving less?

On the one hand, it makes less sense to save now, considering the reduced gains in purchasing power. On the other hand, the purchasing power of your pension will grow less than expected, meaning you have to save more to keep your real pension (corrected for inflation) at the desired level.

We have also observed the reverse scenario taking place; as the economy grew rapidly during the end of the 90s, and real interest rates were high, saving and investing earned relatively high yields. Simultaneously however, a lot of people thought that saving more wasn’t necessary at these high interest rates. They could consume more without any issue; their current savings were growing rapidly in purchasing power anyway. 

It’s therefore impossible to say whether people will save and invest less when real interest rates are low; they are confronted with two opposite effects. Arguments that predict economic disasters on the basis that saving is discouraged thus lack any theoretical foundation.

It is also often said that low real interest rates create bubbles in particular financial assets, and that as they crash or deflate, this would be favorable for gold. This may happen, but doesn’t have to. It depends on whether people choose gold as one of their safe havens. Possibly, but no necessity. 

Gold and Financial Repression

However there is still a connection between the attractiveness of gold as an investment, and interest rate levels.

As we have seen last week, the most important argument against investing in gold is that it doesn’t pay any dividends.

The relevance of this argument depends on the average profitability of businesses in the economy, as well as nominal interest rate levels. After all, this is what a gold investor foregoes; his so-called ‘opportunity cost’ for holding gold.

During a financial repression — or, policy-induced low nominal and real returns on the financial markets — this argument is less relevant than it would normally be. During such times, foregone interest or dividend payments are far lower. While at the same time, gold’s value as a tool for diversification and its opportunities to gain in value are bigger than they are normally.

In other words, lower nominal interest rates mean that gold becomes relatively more attractive, compared to other investments like stocks and bonds. 

Gold and the Speculative Investor

As such, it can push more investors who invest in stocks and bonds, towards gold. However, the same principle applies to other stores of value: jewelry, valuable art and cash. Whether or not the gold price will rise depends on the specific behavior that investors exhibit. Will gold become one of the stores of value which investors will seek out as a safe haven when faced with financial repression?

From a theoretical standpoint, there’s not much to say. This is the domain of a speculative investor that follows the gold market closely, anticipates certain developments, wants to profit from them, and is prepared to take the accompanying risks.

From a theoretical standpoint, you could only argue that a policy of financial repression creates the circumstances that could lead to higher gold prices, thereby potentially providing a valuable investment opportunity. But there is no inexorable causal relationship

In sum, the real interest rate story is a half-truth. A classic case of knowing the outcome, but not knowing how we’ve gotten there. 

Gold and the Risk-Averse Investor

You could say there are two natural types of investors: the speculative investor and the risk averse investor.

Both types of investors try to earn a different type of income in the market economy; the speculative investor tries to earn above-average yields trough speculative investments, while the risk averse investor tries to earn the average rate of return in the economy.

Speculative investors focus on specific trends, industries, companies or assets. They may also focus on temporary price imbalances. They try to earn an excess return over the market average by utilizing superior information or knowledge.

Risk averse investors try to capture the market average, without going through too much ups and downs.

The upward potential of gold due to low real interest rates, during an (upcoming) policy of financial repression, creates investment opportunities for speculative investors. Investors may speculate on this, if they are prepared to accept the risks.  

For risk averse investors, gold may provide a valuable diversification in their portfolio, considering gold usually reacts differently to events in the (financial) world than the 'traditional' asset classes do.

Compared to regular asset classes, gold is a particularly attractive hedge during times of financial repression. It is less vulnerable to government policies that are created to support the local Treasury. And as we have seen last week, this is important to take into account, even for investors in the western world.

Individual investors can harbor both types of investors (risk averse and speculative). An investor could very well decide to invest part of his/her capital in assets that are as safe and diversified as possible; while at the same time having a second budget to invest in speculative investments, which he is prepared and can afford to lose. 

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