Interest rates

If the price of gold continues to fall, it won’t be because interest rates are rising

Gold prices will plunge in the coming weeks, according to one of the strongest correlations ever seen in the markets. Except you shouldn’t put any weight on that correlation.

That doesn’t mean gold won’t decline. But a proper assessment of gold’s outlook must be based on more than a statistical model that has no theoretical basis. This is the case of the one who has many worried gold bugs.

I’m referring to the inverse correlation between the real interest rate (as measured by the 10-year Treasury Inflation-Protected Securities Yield, or TIPS) and the real price of gold GC00,
(as measured by the ratio of the nominal price of gold to the consumer price index). As you can see from the graph below, the r-squared of this correlation is a statistically impressive 0.75. Historically, 75% of changes in one of these data sets predicted or explained changes in the other.

To put that r-squared into context: most models that capture Wall Street’s attention have r-squares close to zero, even if they’re statistically significant – which is rare.

If this correlation is significant, gold could be in big trouble. Claude Erb, former commodities fund manager at TCW Group, said in a recent email that if you were to believe that this inverse correlation would persist into the future, his message is that gold is overvalued. If the yield of TIPS were to rise even more, gold would have to fall even more to become fairly priced.

The key question is therefore whether to believe that this correlation will persist. Erb does not, pointing out that correlation is not causation. He has compelling reasons to question it, which he put forward several years ago in a study he co-authored with Campbell Harvey, professor of finance at Duke University. I refer you to that study for a fuller discussion of these reasons, and I will briefly summarize them here.

1. Unknown direction of causation: One reason is that even if the correlation in this case were causation, we still wouldn’t know the direction of the causation. “While it is possible to argue that historical data suggests that low real yields ’cause’ high real gold prices…it is also possible to argue that the causality runs in the other direction and that high real gold prices actually “cause” low real returns.” If this were the case, the implication of correlation on investments would be that real interest rates should be lower in the weeks and months ahead Correlation would give no idea of ​​the direction gold is heading himself.

2. Much different correlation in the UK than in the US: Another reason to question the strong inverse correlation between the real price of gold and real interest rates in the US is that the corresponding correlation in the UK is much weaker. The r-squared in the UK is only 0.09, according to Erb and Harvey, which is barely enough to praise. I know of no theoretical reason why it should be so different in the US and the UK, and the existence of this discrepancy raises serious doubts about the significance and reliability of the correlation.

3. No plausible theory as to why the correlation should exist: Perhaps the most compelling reason to question what correlation might tell us is that there is no plausible theoretical justification for why it should exist. This is a crucial point, because it is possible to discover a myriad of correlations with even more impressive r-squared but which nevertheless do not make any sense. An example given by Erb and Harvey in their study is the correlation between the historical price of gold and time, which has an even higher r-squared than the correlation between gold and interest rates. The implication of this correlation is that the price of gold is always rising and will eventually reach infinity, which is not only useless for market timing, but also “hard to grasp”, as Erb et al write. Harvey.

In a recent email, Erb provided another example of a false correlation: between the actual price of gold and the amount of atmospheric CO2 measured at Mauna Loa Observatory in Hawaii. Erb calculates that this correlation is just as strong as between real interest rates and the real price of gold. Needless to say, there is no theoretical explanation as to why the price of gold should be tied to greenhouse gases.

The bottom line? Unless you can tell a plausible story for why there should be an inverse correlation between real interest rates and the real price of gold, and in turn a plausible story for the direction of causality between the two the correlation is little more than, as Erb said quoting Ralph Waldo Emerson, “the senseless consistency” which is the “hobgoblin of small minds”.

Mark Hulbert is a regular MarketWatch contributor. His Hulbert Ratings tracks investment newsletters that pay a fixed fee to be audited. He can be reached at

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