The global financial marketplace is a complex dynamic force that impacts almost every facet of life on earth. The complex organism is so interwoven with global economics that even the most studious economist can only guess as to what might follow any given scenario that could unfold. But even amidst the cacophony of the financial markets, certain relationships behave in patterns and move in predictable ways making it possible to predict specific asset class actions, if not the global economy as a whole.
The main inter-market relationship goes as follows: currency up (US dollar) – commodities down – bond prices up – stocks up. The inverse is also true. There are definitely response lags in these relationships, since not all react at once. Other factors can influence this relationship as well. Notice how commodities is the only asset class that have an inverse relationship with everything else. Based on this model, it would make sense that gold, a commodity, would have an inverse relationship with Treasury yields. But analyzing this relationship is fraught with pitfalls, and is the source of some of the most commonly widespread economic misconceptions.
Correlation and Causation
Every novice analyst knows that correlation doesn’t equal causation. In other words, if someone was to find a dataset that showed a correlation between the price of ice cream and the number of college dropouts, it would be wrong to assume the two have anything to do with each other.
In the case of gold and Treasury yields, there’s definitely been an observed inverse correlation. And if gold prices and yields are inversely correlated, then that must mean gold and bond prices are positively correlated.
Gold and bonds are both used by traders as a common safe-haven hedge. When volatility is high and stocks are behaving erratically, investors tend to flock to assets that hold their value better. A vote of no-confidence in the stock market can translate into a bullish rise for both Treasuries and gold prices. If the Federal Reserve takes action such as increasing the money supply through bond purchases, this will lift bond values as well, while sending investors a message that the economy may be weak – something that helps gold prices go higher.
But interest rates are the real underlying fundamental force between gold prices and Treasuries. If inflation rises faster than the yield of the 10-year Treasury making real rates negative, then gold becomes a wealth preservation trade. It might not offer investors a yield, but it does protect against the devaluation of their money. In this kind of scenario, interest rates may rise along with inflation, but if real rates are still negative, then gold prices should rise along with them – while the price of bonds falls.
Investors should note that any correlation, positive or negative, between Treasury yields and gold prices needs to be taken into context with other macroeconomic factors like inflation. The real influential power between these two asset classes is the real rate of return. As long as the yield on the 10-year Treasury exceeds inflation, then an inverse correlation between yields and gold prices should follow. But if real rates turn negative, the standard correlation investors usually see can quickly fall apart, turning gains into losses for unaware traders.