The price of the world’s favorite precious metal remains near its three-year high range, but for gold bulls, that’s disappointing. Soaring inflation in the wake of the pandemic should have now pushed the price well above the current $1,962 an ounce, complains its most zealous proponents. But while inflation is, or at least can be, a factor in the price of gold, real (inflation-adjusted) interest rates and the US dollar tend to dominate prices. According to this reasoning, the surge in real rates in recent years explains a lot. It’s no wonder, then, that CapitalSpectator.com’s “fair value” gold model, which uses the greenback and real rates, still indicates that the precious metal’s valuation is high.
Gold bugs can be prone to disagree. After all, the price of the metal has been constrained for the past few years and recently made another (failed) attempt to decisively break through the ceiling above $2,000.
Disappointing if you bought into the narrative, last year’s inflation spurt would take gold between $3,000 and $5,000, as some of the metal’s most enthusiastic proponents had predicted. But our fair value model throws cold water on that idea. Echoing the analysis published in May, today’s update continues to suggest that the current price of gold remains well above the estimate implied by the current levels of the US dollar and real rates.
Using the 10-year Treasury Inflation-Indexed (TIPS) as a proxy for real yield with a measure of the US dollar suggests that the price of gold near $2,000 an ounce is significantly overvalued…again.
Running the numbers using monthly data (as opposed to daily in the chart above) and replacing the TIPS yield with the nominal 10-year Treasury rate minus the year-over-year change in the consumer price index (CPI) tells a similar story. (Current data is indicated by the blue dot in the table below.)
Why should real rates and the dollar be such dominant forces in estimating the fair value of gold? The empirical record for one. Gold tends to trade inversely to these two factors with good regularity. For what? Competition for scarce investor resources is probably the best answer. Gold earns nothing and so there is an opportunity cost to owning it compared to cash, bonds, stocks and real estate. When real rates are low or negative, the opportunity cost fades or disappears altogether. But the actual rates (based on TIPS) are relatively high, close to the highest in over a decade. Ergo, a “safe” inflation hedge is available. It’s tough competition for gold. An additional headwind for gold: The Federal Reserve, although slow to start, appears to be getting a head start in controlling inflation.
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