**Updated version (the charts only) of my October 2010 post On the Value of Gold:**

I've been a gold bull for a while now (see my post Ready to Ride the Golden Bubble from March 2009), but my rationale was more behavioral in nature. But now, Crossing Wall Street has a fascinating post on a possible model (or at least a framework) for the price of gold, which indicates we are nowhere near the peak.

I highly recommend reading the full post as it provides a nice background for why the model may work, but to the magic formula:

Whenever the dollar’s real short-term interest rate is below 2%, gold rallies. Whenever the real short-term rate is above 2%, the price of gold falls. Gold holds steady at the equilibrium rate of 2%. It’s my contention that this was what the Gibson Paradox was all about since the price of gold was tied to the general price level.

Now here’s the kicker: there’s a lot of volatility in this relationship. According to my backtest, for every one percentage point real rates differ from 2%, gold moves by eight times that amount per year. So if the real rates are at 1%, gold will move up at an 8% annualized rate. If real rates are at 0%, then gold will move up at a 16% rate (that’s been about the story for the past decade). Conversely, if the real rate jumps to 3%, then gold will drop at an 8% rate.I wanted to see for myself, so I took Eddy's model and updated real T-Bill rates with historical T-Bills rates and historical CPI figures going back to 1951, then sized it so the output matched the current price of gold

*(this was not resized in the updated post)*.

And while he is not trying to explain 100% of gold's movement, but rather the factors that drive that movement... the result in itself is rather impressive to say the least.

*Log Scale*

His six takeaways (summarized):

- Gold isn’t tied to inflation, but rather tied to low real rates (not always one in the same)
- When real rates are low, the price of gold can rise very, very rapidly
- When real rates are high, gold can fall very, very quickly
- Gold should not (and does not) have a long-term relationship with equities
- Low rates are likely to last for a long period of time
- Gold price is political; central bankers can crush the price if desired (i.e. raise rates)

Data Source: Measuring Worth

Love your blog and the fact you are keeping it going again!

ReplyDeleteAs to the last point (capital wasted) - someone sells, someone always buys, no? If the price would tank, no capital would be "released" from gold stocks, it would just be destroyed as gold's "market cap" declines.

I find gold interesting to watch, but I am reluctant to buy it.

Thanks... didn't mean to keep that in (the conversation will wait for another day, but I did respond to that in the original). Removing for now...

ReplyDeleteInteresting model. Could you go into a bit more detail on your calculations? Did you use the 3-month bill rate and annualize it? Thanks. Feel free to email me at: seth2077@yahoo.com

ReplyDeleteSeth- Go to the original post as I included a link to a spreadsheet back then.

ReplyDeleteThe implications of this model are a significant increase in the price of gold give the announcement of target rates of 0-25bps and assuming inflation of 1-3%, ie. negative real rates likely for the next 2 years.

ReplyDeleteThis would put the growth of Gold at north of 8% and more likely at 16-20% annually for the next two years, ie Gold at 2630 in 2 yrs.

I would really appreciate seeing your spreadsheet as I am wrestling with how to get the real rates.

sc

How do you calculate the real rates?

ReplyDelete