A key headwind: Why real interest rates affect gold prices

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While I still believe that the precious metal should be a part of a diversified portfolio, I see four reasons why gold prices are likely to decline going forward.

1. Gold prices are facing the headwind of rising real (adjusted for inflation) interest rates for the first time in years. An environment of rising real interest rates, like the one we’re in today, should create a less supportive environment for gold prices. This is because real interest rates, which equal nominal interest rates minus inflation, are essentially the cost of holding gold, an asset that generates no interest income. When real interest rate are rising, as they are today primarily thanks to an increase in nominal rates, investors holding gold are forgoing more and more interest income.

Market Realist – The graph above shows the real interest rates since 2011. The bank prime loan rate serves as a proxy for nominal interest rates. Nominal interest rates minus the inflation rate result in real interest rates.

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As you can see, real interest rates moved up steeply from late 2011 until Q2 of 2012. Since then, they’ve sustained those levels. The trajectory, though, is upward. However, with QE3 slated to end this month, the Fed could increase rates soon. This will increase real rates if inflation remains constant—which seems likely, given how inflation has remained below 2% despite the Fed’s efforts to move it higher. The rising real rate decreases the attractiveness of investing in gold (GLD)(IAU) since investors would rather invest in more attractive bank deposits.

An additional headwind for gold is equities. American (SPY)(IVV) and international equities (QWLD) may still provide better returns. The recovery in major global economies should gain steam over the next few years.

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