Treasury Yields vs Gold

Recently, there has been a lot of media coverage highlighting the inverse (or negative) relationship between treasury yields and the price of gold.

In this article we explore this relationship, and see if it explains why the price of gold has been falling since it reached record highs in August 2020.

The following chart shows the 10-year treasury yield vs the price of gold for the past 15 years.

Here we can see a fairly strong inverse correlation between the two metrics; for example - when yields trend up, gold trends down – and when gold trends up, yields trend down.

Figure 1 – Inverse Correlation Between 10-Year Treasury Yields (Blue) vs Price of Gold (Orange)

To understand why this inverse relationship occurs, we need to investigate the key macroeconomic factors driving both metrics:

1. Inflation and future inflation expectations – determined by the market

2. Interest rates and expected future rates – set by the Federal Reserve

3. Fiscal policy and budget deficit – controlled by the US government

How Inflation Effects Gold and Yields

The following diagram shows how an increase in inflation (and inflation expectations) effect both gold and treasury yields.

Figure 2 – Why Inflation Effects Gold and Bond Yields

Here we can see increasing inflation causes a reduction in purchasing power of the USD, reducing the value of fixed coupon assets (such as treasuries), and ultimately causing the price of gold and treasury yields to increase.

Perhaps surprisingly, we see inflation causes a positive correlation between the two metrics.

How Interest Rates Effect Gold and Yields

Next we look at how increasing interest rates (and expected future rates) effect both gold and treasury yields.

Figure 3 – Why Interest Rates Effect Gold and Bond Yields

Here we see that increasing interest rates increases the return for holding USD, causing money to flow away from financial assets (including gold and bonds), and into term deposits. Reduced demand leads both gold and bond prices lower, increasing treasury yields.

Interest rate fluctuations are therefore causing an inverse relationship between gold and yields, driving the two metrics in opposite directions.

How Fiscal Policy Effects Gold and Yields

The final key driver is increased fiscal spending and higher budget deficits which are executed by the US government.

Figure 4 – Why Fiscal Spending and Deficits Effect Gold and Bond Yields

Here we can see fiscal spending increases both inflation expectations and the supply of government bonds, having a double effect of increasing yields. The additional inflation also increases the price of gold. Thus fiscal policy is actually another driver which does not cause an inverse relationship.

Removing Inflation From the Chart

So in summary, we have two key drivers causing a positive correlation (changes in inflation, and fiscal stimulus) and one driver causing a negative correlation – interest rates fluctuations. This indicates the chart is in a constant tug-of-war, albeit with negative correlation dominating - indicating interest rates are the dominant driving force.

We can therefore refine the chart such that it focuses on the negative correlation by removing inflation (which is causing most of the positive correlation).

We do this by subtracting the 10-year expected inflation rate from the ‘nominal’ 10-year treasury yield – resulting in a chart which shows the ‘real’ 10-year treasury yield. Figure 5 shows a comparison between the nominal 10-year yield and real 10-year yield.

Figure 5 – Real 10-Year Treasury Yield (Blue) vs Nominal 10-Year Treasury Yield (Orange)

Here we can see they mostly trend in tandem, with the real yield below the nominal yield. The one exception is just after the global financial crisis in late 2008, where the two curves are intersected for several months, indicating expected inflation was zero at this time.

Figure 5 also shows that real yields have been close to zero or negative since 2011, and they were at record lows of -1% for most of 2020. This indicates lenders to the US government are only barely breaking even, or often making a loss after inflation. This is only sustainable if the major lender is the Federal Reserve.

We can also remove inflation from the price of gold by dividing it by the consumer price index to get an inflation adjusted gold price.

Figure 6 shows the real 10-year yield vs the inflation adjusted price of gold. This chart has removed the inflation components which were causing positive correlation, and thus we can see a very strong inverse correlation.

Figure 6 – Real 10-Year Treasury Yield (Blue) vs Inflation Adjusted Price of Gold (Orange)

However, although the inverse correlation is strong, it is not perfect, with the chart showing two periods with gold and yields were trending in the same direction (green shaded areas).

This demonstrates that gold and yields are also subject to independent market forces – such as physical supply and demand, sentiment fluctuations, political agendas, and market manipulations – and these independent forces can overpower the key drivers for short periods.

Gold and Treasury Yields Today

So where do we stand today? The US government is currently stimulating the economy at record levels and generating record budget deficits; the Federal reserve is keeping interest rates very low levels for the foreseeable future; And inflation expectations are rising due to limited supply of goods and services, and record fiscal and monetary stimulus.

Despite this, in 2021 so far we have had a declining gold price and rising real yields, which seems counter-intuitive given the aforementioned economic climate. We believe this is being driven by the following factors:

• The US government is delivering record amounts of stimulus in response to COVID19, which is flooding the market with treasuries to allow the government to raise capital.

• At the same time, an exemption which has allowed banks to exclude treasuries in their leverage ratios (SLR) is set to expire at the end of March. This expiry significantly reduces the demand for treasuries, with banks no longer able purchase unlimited amounts of government debt.

This large and sudden increase in treasuries supply, combined with reduced demand, is undoubtedly having a huge impact on today’s nominal 10-year treasury yields, and with inflation expectations somewhat lagging, real yields are also rising.

We can also see short term traders and algorithms selling gold in a somewhat self-fulfilling expectation that the negative correlation between the two metrics must be maintained.

The US Government passed a record $1.9million stimulus package last week

However we believe gold’s down-trend will be short lived as the markets realise gold’s fundamental drivers have not changed, and that long term pressures remain for gold to increase. What we are describing is a typical short term correction in a long term gold bull market.

We also anticipate the uptrend of real yields to reverse soon, with expected inflation to rise dramatically due to the combined government stimulus and quantitative easing programs, and with no interest rate hikes from the Federal Reserve on the horizon.

There is also a high chance that the Federal Reserve will grant an extension for banks to continue holding large amounts of treasuries under SLR exemption in order to calm the bond markets and allow the US government to continue raising cheap capital. This would quickly reinstate demand in the primary bond markets, causing real yields to fall once more, and the price of gold to recover.

By analysing the relevant macroeconomics, we have shown that treasury yields and the price of gold are essentially two side of the same coin. Although they do not directly influence each other, they are both effected by the same driving factors.

Treasury yields and the price of gold are useful barometers for the health of our financial systems, and as such we continue to follow both metrics closely.