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A Reprise of The Elfenbein Gold Model

How gold and currencies run together effects gold prices

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Now here’s the kicker: there’s a lot of volatility in this relationship. According to my back test, for every one percentage point real rates differ from 2%, gold moves by eight times that amount per year. So if the real rates are at 1%, gold will move up at an 8% annualized rate. If real rates are at 0%, then gold will move up at a 16% rate (that’s been about the story for the past decade). Conversely, if the real rate jumps to 3%, then gold will drop at an 8% rate.

Here’s what the model looks like against gold over the past two decades:

The relationship isn’t perfect but it’s held up fairly well over the past 15 years or so. The same dynamic seems at work in the 15 years before that, but I think the ratios are different.

In effect, gold acts like a highly-leveraged short position in U.S. Treasury bills and the breakeven point is 2% (or more precisely, a short on short-term TIPs).

Let me make this clear that this is just a model and I’m not trying to explain 100% of gold’s movement. Gold is subject to a high degree of volatility and speculation. Geopolitical events, for example, can impact the price of gold. I would also imagine that at some point, gold could break a replacement price where it became so expensive that another commodity would replace its function in industry, and the price would suffer.

Instead of explaining all of gold, my aim is to pinpoint the underlying factors that are strongly correlated with gold. The number and ratios I used (2% break-even and 8-to-1 ratio) seem to have the strongest correlation for recent history. How did I arrive at them? Simple trial and error. The true numbers may be off and I’ll leave the fine-tuning for someone else.

In my view, there are five key takeaways:

  1. When real rates are low, the price of gold can rise very, very rapidly,
  2. When real rates are high, gold can fall very, very quickly,
  3. There’s no reason for there to be a relationship between equity prices and gold (like the Dow-to-gold ratio),
  4. The TIPs yield curve indicates that low real rates may last for a few more years,
  5. The price of gold is essentially political. If a central banker has the will to raise real rates as Volcker did 30 years ago, then the price of gold can be crushed.

Perhaps the most significant takeaway is that gold isn’t tied to inflation. It’s tied to low real rates which are often the by-product of inflation. Right now we have rising gold and low inflation. This isn’t a contradiction. (John Hempton wrote about this recently.)

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