What Does A Flattening Yield Curve

Mean For Gold?

January 23rd, 2012 by Sam Kirtley

In this article, we look to analyse the relationship between gold and the U.S.
bond yield curve. The yield curve is an immensely useful economic indicator
and hence can be used as one of the determinants of the gold price.
We have yield curve dynamics, for a refresher the following excerpt should
aid in comprehension of this article.
For those readers who may be unfamiliar with how the yield curve works,
we will provide a brief explanation. Bonds of different maturities have
different yields. By plotting these yields against their maturities we can build
a yield curve. The yield curve becomes steeper if longer term interest rates
increase relative to shorter term interest rates. The yield curve becomes
flatter if longer term interest rates decrease relative to shorter term interest
rates. One way to measure the steepness of the yield curve is to look at the
difference between the yields at two different points on the curve. For
example one may look at the difference between the yields on 2 year
Treasuries compared to the yield on 5 year Treasuries. Such a comparison
will often be referred to as 2s5s and is measured in basis points (bps) by
subtracting the shorter term yield from the longer term yield. So if one says
2s5s are trading at +225 this means that the yield on 5 year bonds is 2.25%
higher than the yield on 2 year bonds. If 2s5s go from +225 to +275 then
the yield curve has steepened between those two maturities. If 2s5s go from
+225 to +175 then the yield curve has flattened between those two
maturities.
Intuitively, one would expect a flattening yield curve to be bullish for gold.
Flatter yield curve = economic weakness = safe haven assets (gold)
becoming more valuable, especially if such weakening in the economy is
followed by monetary easing, or increased expectations of monetary easing.
As with any hypothesis, this one is useless without being tested.

The above graph inversely plots gold against yield curve gradient. The early
trend is clearly quite strong, ie yield curve flattening and gold rising
correspondingly. Around September 2011 the relationship becomes shakier.
From September onwards, the trend seems to take a dramatic reversal,
switching from negative to positive. Trying to explain this reversal is
somewhat a case of speculation. The only thing that can be said with
certainty is that other factors are proving more important in determining the
gold price.
The graph below plots gold against yield curve steepness rather than time,
over the last 12 months.
The trend is
clear. Gold is driven higher when the yield curve flattens, exactly what one
would expect to see. The R
2
value shown of 0.6817 means that 68% of the
variation in the price of gold can be determined by changing yield curve
gradient.
As a trading service, we have a short to medium term focus. As a result the
majority of useful information to us is very timely. For this reason the trends
and relationships we observe must hold not only over the long term, but the
short-medium term also. We cannot afford to wait five years for the market
to return to where a certain model says it should be. As a result the plot
below showing the trend since September is potentially the most important
of this update.

As hinted at, the trend has shifted mildly positive, meaning a steeper yield
curve = gold driven higher. However, the relationship is extremely weak
(shown by an R
2
value of 0.1348) and is too inconclusive for our purposes.
The conclusion is that currently there is no relationship between the
steepness of the U.S. Yield curve and the price of gold. We can safely
assume other factors have been significantly more important in the
determination of the gold price in recent months.
The correlations for differing time frames over the past four years are as
follows:

Note: Correlation (r) is not to be confused with the coefficient of
determination (R
2
).
What we can draw from these results is that over the medium term gold
exhibits a moderate negative relationship with the gradient of the U.S. Yield
curve. True to intuition we still believe a flatter yield curve (usually resulting
from monetary easing) is a bullish signal for gold.
Imagine that the Fed eased further, causing the yield curve to become
flatter still. This is a scenario observable in Japan, a country currently with
an extremely flat yield curve resulting from an extensive period of monetary
easing. As an example, assume 2s10s drop to 50 basis points. What is this
likely to mean for gold? Depending on what model we use the following
values are predicted:

Obviously the most accurate figure depends on ones current assessment of
the relationship between gold and the U.S. yield curve over the relevant
investment period. Our estimation is for a moderate negative relationship to
re-establish itself over the next 12 months. If we were to be proven correct
and the Fed dropped 2s10s to 50bps in the next year, one would expect to
see gold around the $1,923 level shown above. The nature of using a
moderate relationship rather than a strong one to predict a variable is that
the predicted value lies within a very wide range; the stronger the
relationship (R
2
value) the more accurate the prediction.
Conversely, what would one expect gold to sit at given some miracle
economic recovery and the yield curve becoming significantly steeper?

True to intuition a steep yield curve (similar to 2003-2004 peaks) would see
gold bottom according to our model.
It is important to remember that these scenarios are nothing more than
estimates based on simple mathematical models and past data. Models and
data carry little weight when dealing with an animal such as the commodities
market. With so many variables at play anything could happen. We use
these scenarios and examples to help communicate concepts and give our
readers an understanding of what it means for gold when a flattening yield
curve is observed. In practice and behind the scenes we are definitely not
using weak relationship yield curve regressions to predict the gold price.
It is important to reiterate the yield curve is an indicator for the whole
economy. For our purposes as a trading service the yield curve isnt the best
form of information. It is a reflection of past, present and future expected
events. What is of more use to us is present/future orientated information.
For example say the Fed hints at QE3 or some other form of easing
tomorrow (further easing is very likely to send gold higher); as soon as we
receive this news, our outlook on gold changes on the back of the
announcement. We do not need to wait to see a flatter U.S. yield curve in
the following hours, days or weeks to change our position.
Although we acknowledge the importance of the U.S. yield curve in the
determination of the gold price, it is not the most important factor by any
stretch. The relationship between gold and the yield curve varies in strength
over time, and hence the curves usefulness is somewhat limited. U.S. real
rates are a far better predictor and exhibit a much more constant, direct
relationship to gold.
The crucial point to take away from this article is it is not economic
weakness that drives gold prices higher. It is the policy response to that
economic weakness. A weaker economy and flatter yield curve doesnt
necessarily mean that gold prices will go higher, but if this is going to be
combated by an aggressive easing of monetary policy such as quantitative
easing then gold prices will rise significantly. U.S. real interest rates are
therefore a more effective indicator for gold prices over the medium term,
since they are sensitive to a wider range of policy actions.
There are always multiple factors that drive asset prices in the financial
markets and gold is no exception. One has to incorporate a numerous
variables in ones analysis in order to formulate a view. The yield curve is
just one of these variables and sometimes it gives us valuable insights into
future of gold prices, but it cannot be expected to work 100% of the time.
In our analysis we look at numerous factors to form our view on gold prices,
with the yield curve being just one of these, and we then execute trades
based on these views. Our subscribers get market updates, trading signals
and our model portfolio for less than $1 per day. Our model portfolio
returned 40.95% in 2011, versus a 9.92% return for gold. We trade options
on US markets that can be traded as easily as basic stock options. We now
also issue trading recommendations that are not options based but simply
use ETFs when we feel that that is the optimal way to execute a trade.