US FINANCIAL SECTOR ie BANKS
by plotting the financial sector against gold. As the fear of a financial collapse waned, financials headed higher and gold headed lower. The more confidence there is in the financial sector recovery, the higher the financial sector has gone and the lower gold has gone. Gold looks almost like the mirror image of the financial sector since mid-2011 when gold peaked.

(click to enlarge)

 

AUDUSD and GOLD
Gold traders may also be surprised to hear that trading the Australian dollar is just like trading gold in many ways. As the world\’s third-largest producer of gold, the Australian dollar had an 84% positive correlation with the precious metal between 1999 and 2008. Generally speaking, this means that when gold prices rise, the Australian dollar appreciates as well. The proximity of New Zealand to Australia makes Australia a preferred destination for exporting New Zealand goods. Therefore, the health of New Zealand\’s economy is closely tied to the health of the Australian economy, which explains why the NZD/USD and the AUD/USD have had a 96% positive correlation over the same time period. The correlation of the NZD/USD with gold is slightly less than that of the Australia dollar but is still strong at 78%.

GOLD AND 10 YEAR BOND YIELDS and INTEREST RATES

That however is not how gold has been behaving. Gold has been demonstrating direct correlation with bonds and inverse correlation with interest rates – the exact opposite of what would happen if gold was acting as an inflation hedge.,

That observation has not gone unnoticed, as Claude Erb, a former commodities portfolio manager for Trust Company of the West and co-author Campbell Harvey, a Duke University finance professor, highlight in a recent National Bureau of Economic Research Report entitled “The Golden Dilemma.”

In the report they highlight that gold and the 10-year treasury yield have an R-Squared of 0.78.

In the case of the gold-interest rate correlation over the last decade, Erb told me in an interview, the r-squared is a very high 0.78. (Click here for a summary of his findings.)

Most correlations on Wall Street don’t come anywhere close to being that high. Indeed, many of the drugs that get FDA approval have lower r-squareds between their use and positive medical outcomes.

As pointed out, that is a very high R-Squared for these kinds of relationships. The author then used this simple single variable model to forecast the price of gold given various interest rates. He claims that a 3% yield on the 10-year Treasury would translate into a gold price of $1,196.70/oz, a 4% yield would result in a price of $841/oz for gold, a 5% yield would take gold down to $471/oz and that it would take a 1% yield to get gold back up to $1,900/oz.

If the 10-year Treasury yield rises to 5%, gold will fall to $471 an ounce… And if that yield rises to just 4%, from its current 2.8%, gold will still plunge – to $831… for gold to make it back to its all-time high above $1,900 an ounce is for the 10-Year Treasury yield to fall to 1%… At the beginning of 2013, of course, that yield stood at 1.76%, and gold bullion stood at nearly $1,700. He told me that the model at that time would have predicted bullion’s price would be $1,196.70 when the 10-year yield hit the 3% point.

That point was reached on Dec. 26 of last year, and the London Gold Fixing price on that day stood at $1,196.50.

That counts as hitting the bulls eye.

Why this is so important is because gold is acting in a counterintuitive manner. The classic relationship of gold to inflation has been flipped on its head. Unlike past times when gold performed well when inflation developed, it is likely that gold will do just the opposite this time, at least in the early to mid stages of this recovery. The reason gold has such a lofty value isn’t because of inflation from printing all this “money out of thin air,” it is because of fear of a financial collapse. Gold has a fear premium built into it, not an inflation premium.

Higher interest rates will signal economic recovery, a return to normalcy, a lowering of the risk of a financial collapse, higher inflation and lower gold prices. The key is that the fear premium has to be removed before an inflation premium gets built in. The cycle in gold therefore is likely lower gold prices in the near to intermediate future, then a period of consolidation as the economy picks up steam, but not so much as to threaten undesirable levels of inflation, and then a tightening labor market, the emergence of demand driven inflation and then higher gold prices as the inflation premium starts to build. That however may be a long way off given the tremendous excess capacity that exists in the labor market.

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