Has gold’s relationship with interest rates changed?

Gold is negatively correlated with real interest rates. This was the conclusion we came to in our analysis back in September 2020, which described gold as being in the middle of a “tug of war” between interest rates and inflation.

Now that inflation is high and interest rates are rising across the curve, we thought it would be helpful to assess whether that conclusion still holds and what it means for gold as an asset class in this new era.

Looking at this recent period as well as historical data in the chart below, we can see that during rate hiking cycles the correlation between gold and real yields tends to rise from negative to positive. That is, the price of gold goes up together with real yields. This is seemingly contradicts our original finding.

As we explained last time, when risk assets such as equities are driven by plentiful liquidity, as opposed to by strong growth, they are likely to have a negative relationship with real yields.

We suggested that when (or if) liquidity is withdrawn one day, such as when central banks start hiking rates, and real yields rise again, gold would not be a particularly good hedge against an equity market sell-off.

Well, now that withdrawal of liquidity has begun, and equities have accordingly made losses this year. Given our broad-based tug-of-war assertion, we might have expected gold to sell off more than it has done this year so far. But our analysis today explains why gold’s performance has been relatively uninteresting, neither benefiting from flows of money seeking an inflation hedge, nor losing out from the impact of rising rates.

Looking ahead, markets are increasingly focusing on the prospect of stagnant growth and higher inflation - also known as stagflation. In such an environment, gold should be relatively appealing. Most asses classes make losses, so investors seek the best of a bad bunch.  

Gold stands up quite well in this context, as you can see in the chart below. But, as our colleague Ugo Montrucchio recently wrote, there is only one historical period of stagflation in this sample and so drawing conclusions about future performance from this may be somewhat tenuous.

While there haven’t been many stagflationary periods in our historical data, there have been plenty of slowdowns where we’ve observed gold’s correlation with real yields spiking. It is encouraging that gold is again unencumbered by central banks actions. With rate hiking cycles often leading to recession, gold starts to perform by anticipating the upcoming rate cuts and looser financial conditions the recessionary environment necessitates.

Summary

We think the relationship between real interest rates and gold still holds fairly well in most environments. However, when you look at the current economic backdrop in the context of the past 50 years, what we’re seeing regarding inflation and interest rate look like anomalies.

In such an extreme environment, investors should be careful of making decisions based on previously-held assumptions which may be temporarily invalid.