Gold’s Real Bear Market Is Not Over Yet (XAUUSD:CUR)

While gold prices trade near all-time highs in nominal terms, when adjusted for inflation the metal is still 5% below its March 2022 highs and 12% below its August 2020 highs. The metal has also underperformed boring old cash over this period and there is every reason to expect this underperformance to continue. High real interest rates suggest that gold will continue to underperform even if the metal remains decoupled from its historical relationship with real yields.

The Double Negative Impact Of High Real Yields

I have received a lot of comments arguing that the historical relationship between gold and real bond yields no longer holds, as evidenced by gold’s strength in the face of surging real yields. The decoupling of gold prices from inflation-linked bond yields over the past two years can be seen in the chart below.

It has been argued that factors such as central bank buying and huge fiscal deficits mean that gold should trade at a premium to its fair value implied by its historical correlation with real bond yields. While I am sympathetic to the idea that gold will remain elevated due to these factors, this does not mean that the metal will generate strong returns relative to cash. With 10-year inflation-linked bonds offering a real yield of around 2%, this means that bond investors expect interest rates to average 2pp higher than inflation over the next decade. For gold to outperform cash under these circumstances, its real price would have to rise by 2% a year, meaning that gold bulls are speculating on a 22% increase in gold’s real value in order to just break even.

Speculative Interest Warns Of A Correction

The high speculative interest in the gold market can be seen in the following charts. The first shows net non-commercial futures positioning in the metal as a share of open interest, which is in its 74th percentile of readings over the past 30 years.

The next shows the ratio of implied call volatility over implied put volatility, which is trading in the 89th percentile of readings going back to 2007. Taken together this shows that speculators are positioned for further upside and are ill-prepared for a correction.

The next chart shows periods when net speculative positioning is above its long-term average, the ratio of call over put volatility is above 1.1, and gold is more than 10% overvalued based on its historical correlation with real bond yields. These conditions represent only a small percentage of periods going back to 2007, but they have tended to occur around significant price peaks for the metal. Of course, there is no guarantee that history will repeat, but it does suggest significant headwinds for gold prices over the coming months.

Shift To TIPS For A Far Superior Risk-Reward Outlook

As I have argued in previous articles on gold, investors are much better placed in inflation-linked bonds. The PIMCO 15+ Year U.S. TIPS Index Exchange-Traded Fund ETF (LTPZ) for instance, has shown a similar level of volatility as gold over recent years and the 30-day rolling correlation between the two assets has averaged over 80% over the past decade. The LTPZ’s underperformance over the past two years means that investors can now earn over 2% annually above inflation, with significant upside potential should real interest expectations fall sharply as I expect. While gold would also likely rise significantly under such a scenario, TIPS offers far less downside risk given how high real yields have already risen.

Summary

The resilience of gold prices in the face of high and rising real bond yields has come as a surprise but the metal is still significantly below its 2020 peak when measured relative to inflation and the total returns received on cash. At current high real yields, gold bulls are relying on ever-increasing real prices to outperform cash and bonds, and this speculative interest is seen in various futures and options markets. Investors like myself looking to benefit from the eventual decline in real interest rates are likely to be much better off in inflation-linked bonds.