The Mystery of Gold Prices

Many people have suffered trying to make a profit investing in gold. Its price movements defy most people’s theory of how the world works. The Federal Reserve increases its balance sheet to $4 trillion and gold rises for a while, but then sinks like a stone as the Fed continues to buy assets. Nicholas Johnson of PIMCO says the firm believes it has a valid theory of what influences the price of gold.

He says to look at interest rates, real interest rates in particular. These are nominal or market interest rates minus inflation. When real yields fall, the price of gold rises. Johnson says it wasn’t always this way. But since few governments peg the price of gold or make their currencies convertible into it and especially since exchange-traded funds that own gold were created, this was how gold acted in recent years. PIMCO expects gold to act this way in the future.

Using this framework, consider the 15% price drop in gold in mid-April following talk of Fed tapering. This move predated the sharp move higher in yields in the fixed income market by two weeks. Over the month of May, 10-year real yields rose 57 bps. Even though the markets moved at different times, the size of their moves over this period was remarkably consistent with the historically observed 27-year real duration. In hindsight, we believe the move in gold gave an excellent early warning of both the direction and magnitude of the move in rates.