EKIP– Expert Club for Economics and Politics A Different Opinion
After examining the main differences between gold and silver as investment assets in the previous two articles, in this article we will pay attention to three main indicators whose dynamics have a relatively high level of correlation with their price dynamics. First, we will pay attention to the macroeconomic indicator that is most often associated with the movement of the price of gold and silver - inflation.
Gold, silver and inflation
Interestingly, the correlation between the inflation rate and the movement of gold and silver prices is actually not that serious in itself. The graph below shows the movement of the gold price and the consumer inflation rate on an annual basis in the United States between the beginning of 1997 and the beginning of 2017 (the left vertical axis shows the growth of the gold price on an annual basis in percentage, and the left one shows the inflation rate). Visually, we can notice that in certain periods, at least visually, there is definitely a strong correlation between the movement of the inflation rate and the growth of the gold price on an annual basis. However, the statistical linear correlation between the two variables is actually not as strong as it seems at first glance.
Linear correlation measures the extent to which and in what direction a change in the value of one variable is accompanied by a change in the value of another. In the case of monthly gold growth and annual consumer price inflation, over this 20-year period the correlation between the two was 0.4. Roughly speaking, this means that in 40% of cases an increase in the pace of inflation was accompanied by an acceleration in the growth of the price of gold. As for silver, the correlation between its price dynamics and the growth of inflation is relatively lower, 0.33.
Източници: FRED , London Bullion Market Association
It should be noted that the correlation between the prices of the two metals and inflation has been higher in the last 10 years than for the entire period. From the beginning of 2007 to the beginning of 2017, the correlation between the growth of the price of gold and the inflation rate was 0.5, and that between the growth of the price of silver and inflation was 0.4. This is probably due to the fact that since the crisis of 2008, gold and silver have become more popular investments for hedging against inflation than they were before.
As we can see, the inflation rate itself is not a very good indicator of where gold and silver prices will go. This is a very important fact that anyone who intends to invest in these metals should be aware of . What the prices of gold and silver have a very strong correlation with is not the inflation rate itself, but the effects it has on other assets that can serve as alternatives to investing in gold and silver. The two most obvious such assets are cash and government bonds (especially long-term ones).
When the dollar loses purchasing power, gold and silver gain
The second chart below compares the movement of the price of gold (in dollars per troy ounce) and the dollar index, which measures the movement in the value of the US dollar against a basket of currencies of the US's largest trading partners between 2002 and 2017. The chart clearly shows that when the dollar index falls, the price of gold rises and vice versa. Over the past 20 years, the correlation (negative) between the two has been 0.59. Interestingly, the correlation between the dollar index and the price of silver is higher – 0.67.
Източници: FRED , London Bullion Market Association
As we have already established, silver is not only a precious metal but also an industrial metal, and this higher inverse correlation with the movement of the dollar index may be related to this. When the dollar falls against the currencies of other countries, and specifically those that are large producers and exporters of silver to the United States, this means that the price of silver in dollars is likely to rise more than that of gold, precisely because of the industrial consumption and import of silver, which is relatively less elastic than the demand for gold (and silver) for jewelry production and investment purposes.
Cash is the simplest possible alternative investment to gold and silver. In fact, it is the simplest possible investment at all. Like gold and silver, cash is a very safe investment that involves almost no risk, unlike assets such as company stocks, bonds and other financial instruments. The problem, however, is that in a period of price inflation and the correspondingly decreasing purchasing power of a particular currency, the return on cash is negative. And so, when the inflation rate in a given country accelerates, the value of the corresponding currency (in this case the dollar) decreases, which causes investors to switch to precious metals, which in turn increases their price.
The clearest relationship is between real interest rates and gold and silver prices.
But there is one asset whose return has a higher level of correlation with the price of gold and silver than even the dollar. This is the real interest rate on government securities. What is the "real interest rate" on government securities? It is simply the interest rate on these bonds minus the inflation rate. The last chart below shows the dynamics of the real interest rate (in %) on 10-year government securities in the United States between 1997 and the beginning of 2017 compared to the movement of the price of gold (in US dollars per troy ounce).
Източници: FRED , London Bullion Market Association
Here again, there is a negative correlation between real interest rates and movements in the price of gold (and silver). The level of negative correlation between real interest rates on 10-year government bonds is the same with both the price of gold and the price of silver – 0.63. This is the strongest level of correlation that any of the three indicators examined here has with the prices of gold and silver. This is because among asset classes that are almost as low-risk investments as gold and silver, government bonds tend to have the highest returns because they have interest yields. However, this yield suffers from high levels of inflation – when inflation is high, it can even make real interest rates on government bonds negative.
As we can see in the chart, the price of gold reached its highest levels in 2011, when the real interest rate on 10-year US government bonds fell to its lowest level, which was -1.89%. In addition, the long-term trend towards a decrease in the real interest rate is clearly visible, which fell from 4.28% in June 1997 to -0.44% in February 2017. This, quite logically, is accompanied by a long-term increase in the price of gold from $334 per troy ounce to $1255 and in the price of silver from $4.7 per troy ounce to $18.2 - a dynamic that is largely caused by the transfer of investments from government bonds into gold and silver.
Conclusion
The most important conclusion we can draw from this data is that, for the price of gold and silver, the effects of inflation on the purchasing power of money and real interest rates on government securities are more important than its level itself. Remember this very well, because although rare, situations are possible in which the inflation rate increases, but at the same time the purchasing power of the dollar (for example) against other currencies and real interest rates on government securities also increase. Knowing that the price dynamics of gold and silver are much more closely correlated with the dynamics of the returns on these assets than with the inflation rate can help us avoid potential losses in such situations.
