Submitted by Erico Matias Tavares via Sinclair & Co., Are gold prices going to US$ 5,000 or US$500 an ounce? Here's one important component that you might need to consider in your forecast: the direction of US dollar real interest rates. Gold tends to perform well in US dollar terms when US real interest rates are trending lower, meaning that the spread between the interest rate and expected inflation is narrowing, and poorly when they are trending higher. There are several ways to calculate real interest rates; the most insightful attempt to capture investors' future expectations based on actual market data. The US Treasury makes this easy for us, providing real yields on Treasury Inflation Protected Securities (“TIPS”) on a daily basis for maturities ranging from 5 to 30 years, as shown in the graph below. Daily Real Interest Rates for Different Maturities: 2 Jan 03 - Today The question now becomes which of these maturities, if any, is better suited to gauge the relationship with gold prices. In other words, do investors attribute greater weights to shorter-term inflation expectations, like five years, or to longer maturities? While these generally track each other, at times the differentials can be quite significant, as shown in the graph above. Since theoretically we can argue either way, we decided to use the maturity with the lowest correlation coefficient (the lower the real interest rate the higher the gold price). The 10 year maturity was thus selected, with a value of -0.86 going back to January 2003, although the others were not that far off [Note: -1 is the lowest value, meaning perfect negative correlation]. Here’s how the two variables have performed over time. Gold prices have generally followed the opposite trend of 10 year real interest rates (which are shown in the following graph in reverse order), with the exception of 2005. Daily Gold Price (Continuous Futures Contract)(LHS) and 10 Year Real Interest Rates (RHS): 2 Jan 03 - Today Looking at the graph, it seems as if the high negative correlation coefficient is masking the fact that the magnitude of gold price swings appears to lead real interest rates, with its trends bottoming or topping in advance. One explanation is that gold might convey a stronger signal in terms of inflation expectations than the TIPS. It should be noted that this is not the most extensive of datasets, given that the US Treasury only started publishing these real interest rates back in 2003. This period also coincides with the start of the bull run in gold prices, which may be skewing the correlation analysis. It would have certainly been wonderful if we had data going back to the last major peak in gold prices more than 30 years ago. So where to from here? With bond yields already being so low, if the US slips back into deflation this means that real interest rates will trend higher. As we have seen, gold will struggle to move higher in that environment. In fact, some studies show that bond yields tend to mean-revert to 2% in real terms over the longer term, which would be bad for gold from these levels. But this is not the whole story. If deflation starts causing big problems across the financial system, investors may seek refuge in the yellow metal, thus providing some support. Therefore, if gold prices materially decouple to the upside in relation to real interest rates, this would not be a great sign for the capital markets as a whole. We could all become "gold bugs" in the process.