Gold Bugs Put Foot Down Last 2 Weeks, Hoping Cooperation From Real Yields Ahead

In the absence of Fed action, it is possible markets will continue to throw tantrums and the 10-year (1.73 percent) heads toward two percent. It is hard to say what the pain point is but at some point this will begin to matter in a leveraged economy, which will get hurt through higher interest cost (chart here).

The point is, at some point the selloff in bonds gets bad enough it will begin to attract investor interest. Concurrently, odds favor inflation rises in the months ahead. In the 12 months to January, core PCE – the Fed’s favorite measure of consumer inflation – increased 1.53 percent, up from 1.37 percent last November and 0.93 percent last April.

Real yields are a huge driver of gold prices. In Chart 5, the 10-year treasury inflation-indexed security (TIIS) is inverted and shows a tight relationship with gold. These are debt securities with coupon and principal payments indexed to inflation.

TIIS has been in negative territory since February last year. During last August when gold peaked, it yielded an average of just north of minus one percent. So far this month, it has averaged minus 68 basis points. This effective strength has hurt sentiment toward gold. A pickup in inflation, without a commensurate rise in nominal yields, is an antidote to this.

The thing is, gold rallied hard into and during the early months of the fourth iteration of quantitative easing (QE) but was not able keep up the momentum, as it followed real yields closer. Chart 6 uses GLD.

As explained earlier, the Fed set in motion unlimited QE a year ago, but its balance sheet began to expand as early as August 2019 when it held $3.6 trillion in assets. The metal acted similarly during QE3. As soon as QE2 ended, Gold/GLD peaked in September 2011 and was unable to rally during QE3, which lasted from September 2012 to October 2014. Once again, real yields rose during the period – from minus 71 basis points to plus 38 basis points, hurting gold (period indicated by two-sided arrow in Chart 5).

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