Gold Stocks and Interest Rates

Here is an extract from commentary that was posted at www.speculative-investor.com on 17th October 2002. 

Are rising long-term interest rates bullish for gold? The answer is "that depends". Rising long-term interest rates are not bullish for gold unless they are rising relative to short-term interest rates, that is, unless the yield spread is rising. 

There are a lot of ways to calculate the yield spread, but we calculate it by subtracting the yield on the 13-week T-Bill from the yield on the 30-year T-Bond. The yields on T-Bonds, the longest-dated treasuries, are influenced more by the market's perceptions regarding the inflation risk than are the yields on shorter-dated treasuries. T-Bills are the shortest-dated treasuries and have almost no inflation risk factored into their yields. Also, whereas the market controls T-Bond yields the yield on the 13-week T-Bill seldom wanders far from the Fed Funds Rate target set by the Federal Reserve. In other words, the T-Bill yield is primarily controlled by the Fed. 

Further to the above, regardless of what is happening with the absolute level of long-term interest rates the behaviour of the yield spread often indicates whether the market is becoming more or less worried about inflation and also whether the Fed's monetary policy is 'tight' or 'easy'. For these reasons, the yield spread (the level of long-term interest rates relative to the level of short-term interest rates) plays a more important role than the absolute level of long-term interest rates in determining whether or not the interest rate environment is bullish for gold. 

Below is a chart comparing the yield spread and the TSI Gold Stock Index (TGSI). The up-trend in the yield spread between November-2000 and May-2002 was accompanied by an up-trend in the TGSI. However, since May of this year the yield spread has been trending lower, meaning that the interest rate environment has been bearish for gold over the past 5 months. Furthermore, regardless of what happens in the bond market it will remain bearish unless the yield spread once again starts to trend higher.

The downturn in the yield spread clearly isn't the only reason that gold and gold stocks embarked on an extended correction in May of this year. There are always a number of different inter-market forces tugging on the gold price at any time and these forces are seldom all tugging in the same direction. We consider the yield spread to be one of a number of secondary forces, with the US Dollar's trend being the only primary force. However, it will be difficult for gold and gold stocks to experience a major rally until the interest rate environment again turns bullish. The recent upturn in the yield spread may, in fact, be a preliminary sign that this is starting to happen.

Over the next 6 months we think there is a lot more upside potential in T-Bond yields (long-term interest rates) than in T-Bill yields (short-term interest rates), for two main reasons. First, we expect a falling US$ combined with rising commodity prices to result in long-term interest rates moving much higher. Second, continuing economic and financial problems, or, at least, the perception that problems might occur, will encourage the Fed to keep short-term rates near their current low levels. The yield spread is therefore likely to be a lot higher in 6 months time than it is today. This is partly why we remain medium-term bullish on gold and gold stocks. 

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