Why gold performs well in a negative real rate scenario

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2. Exposure to gold is also a useful strategy to take advantage of the negative real-rate environment. Typically, gold is a beneficiary when real interest rates become negative as this lowers the opportunity cost of holding the metal.

Market Realist – The graph above shows real interest rates for the last three years. Real interest rates are nominal interest rates minus inflation rates. We used the bank prime loan rate as a proxy for the nominal interest rate in the graph above.

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The real interest rate has been volatile for the last few years but has remained in a tight range of 1.1% to 2.3%. It currently stands at 1.3%. Low real interest rates are positive for gold (GLD)(IAU), as bank deposits would yield lower on an inflation-adjusted basis. So they make gold more attractive, given the fact that gold rises along with inflation.

Also, low real interest rates may not necessarily be a positive for equities (SPY)(IVV). Stock prices are driven by a number of other factors, including corporate earnings, as we saw in the first part of this series. Plus, low real rates can simply be driven by flat nominal rates and increasing inflation, which can eventually hurt business margins, depending on their pricing power and control over costs.

Bonds benefit when nominal rates are decreasing. But, once the downtrend stops, low interest rates aren’t good. First, they imply a low yield environment, which simply means lower returns. Second, when rates are this low, the risk of rates increasing is higher than the risk of going down further. So the duration risk-to-reward ratio worsens.

Inflation-linked bonds, on the other hand, are driven by expectations of real interest rates, and will therefore outperform if real rates are decreasing, making them a better hedge. The next part of this series explains this tendency in more detail.

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