A look at what macro economic factors make Gold attractive to hold. We look at the relationship between real interest rates and Gold prices and point out how other currencies in the world looking unattractive makes Gold look attractive.
In this video we take a look at how gold competes with other currencies and look at what factors make holding gold relatively more or less attractive compared to other currencies in the world.
Setting up the example
Similar to our previous video, we are going to assume that there are only three currencies in the world: the US dollar, gold and rest of the world (ROW) currencies. If you watched our previous videos you know that the reason we are treating gold as the currency is because a lot of people who hold gold look at it as a store of wealth/value and so they often compared gold to other currencies when they’re trying to decide how to keep their wealth.
We are going to assume that the exchange rate between US dollars and gold is that 1 unit of gold = 1000 US dollars and as we talked about before, because gold is denominated in US dollars, this exchange rate is the price of gold in the market. We are also going to assume that the exchange rate between US dollars and ROW currency is such that 1 US dollar = 2 ROW currencies. Finally, we know from the previous videos that defining these two exchange rates defines the third exchange rate between gold and ROW currency such that 1 unit of gold = 2000 ROW currency.
What makes holding dollars attractive?
Question: if you are sitting in the US, what makes it attractive to hold US dollars? One way to answer the question is to think: “If I’m holding US dollars, the safest thing that I can do with my US dollars is to buy government bonds with it”. Now when you buy a government bond you earn an interest rate that depends upon the interest rate in the economy, so you could argue the attractiveness of the currency depends upon that interest rate. Imagine the interest rate in the US is now 5%. This means you can buy, let’s say, a 3 year government bond that will pay you 5% a year to just keep your money there.
Someone might look at that 5% return and argue that it doesn’t capture the entire picture. So let’s imagine that we have 100 dollars and we put it in a 3 year government bond that pays 5%. So at the end of 1 year we have 100 dollars that we put into the bond plus the 5% percent interest, so we have 105 dollars. Now these 105 dollars 1 year later might not be worth the same as 105 dollars the year before. The reason for this is because you might be able to buy less with those 105 dollars a year later because in that time the price level in the economy might have gone up. Let’s say the price in the economy went up by 1%. That 1% is the inflation rate and we’re going to define the real interest rate as = nominal interest term — inflation rate. So in our example the real interest rate is 5%-1% = 4%. So we think that this 4% real interest rate captures the attractiveness of holding money in US dollars because it is a measure of what we can buy a year later.
When is holding Gold attractive?
Let’s go ahead and think about how attractive each of these other two currencies are by the same metrics. We’ll assume the nominal interest rate in the ROW is 6% and the inflation rate is 1%, so the real interest rate is 5%. What should the nominal interest rates be for gold? When you buy gold you can’t take that gold and invest it in anything, all you can really do is have it sitting around somewhere. So we’re going to assume that the nominal interest rate for gold is 0%. In reality, it’s probably slightly negative because you actually have to pay money to store gold.
What should the inflation rate for gold be? It makes logical sense is to assume that the inflation rate is equal to how much new gold is brought into the whole gold market every year. We know from our previous video that there are about 2,600 tons of gold that are brought into the gold market (that has a total of 165,000 tons of gold in it) every year by miners and that implies an inflation rate of around 1.5% (2600/165000). So this implies that the real interest rate on gold is around -1.5% (0%-1.5%). So when the real interest rate in the US is 4% and ROW is 5%, gold with its -1.5% real interest rate does not look particularly attractive. However, lets imagine the economic situation changes such as a nominal interest rate in the US is equal to 0%, the inflation rate is equal to 5% implying the real interest rate is equal to -5% and in the ROW, the nominal interest rate is 0%, the inflation rate is 4% and the real interest rate is -4%. In this scenario gold with its -1.5% inflation rate starts looking more attractive. When the real interest rate gets lower and lower in world currencies, gold seems like a more and more attractive way to store the value of the money that you’ve learned. In this case where the real interest rates across the world is about -5%, you’d expect a lot of money from the US and the ROW might go into buying gold. All the money flowing into buying gold would likely change this exchange rate between gold and the US dollar such that 1 unit of gold becomes = 1500 US dollars instead of 1000 US Dollars.
Real Interest rates vs. the Price of Gold
So what you might expect to see historically is a relationship between the real interest rate in world currencies and the price of gold.The chart [SLIDE 5] shows the price of gold in US dollars (the pink line) and the real interest rate (blue line) in the US. I’ve excluded the real interest rate in the rest of the world partly to keep things simple and partly because people generally perceive the US dollar as being more safe than ROW currencies and so that data isn’t as important.
The green line on the chart shows where the real interest rate is about -1.5% which is what we are assuming is roughly the inflation rate of gold. Our hypothesis is that when the real interest rate in currencies approaches the real interest rate of gold people will start seeing gold as a alternative currency.The chart confirms this hypothesis to some extent. The circles on the blue lines show periods where the real interest rate is close to or below -1.5% and we see that they often occur at the same time as rallies in the price of gold.
The big picture here is that the price of gold might be related to the attractiveness of keeping money in other currencies and so when you go out and buy gold you are effectively betting that keeping money in other currencies will be increasingly unattractive.
Gold data from Bloomberg
Real Interest Rate calculated from 3 Month Tbill Yields and CPI YOY from Bloomberg