Sell Gold And Buy TIPS (Commodity:XAUUSD:CUR)

There is no telling how much further the rally in gold prices has to go, and speculative demand may well see the metal make a run at its all-time highs of USD2,075. For those of us who are fundamentally minded, however, now does not seem like a good time to invest. The rally is completely detached from its historical drivers. Real bond yields would have to move significantly lower to justify current gold prices. In which case, investors are likely to be better off investing in TIPS themselves.

As I noted earlier this month, short-term moves in gold prices are extremely closely linked with real bond yields, specifically the yield on long-term US TIPS (Treasury Inflation-Protected Securities). When real bond yields are high and rising, this raises the opportunity cost of holding gold, which does not pay any interest. 10-year real bond yields remain near their cycle highs, at 1.2% currently, which reflects 2.3% expected inflation and the 3.5% yield on the regular US Treasury.

As the chart below shows, the last time real yields were at these levels back in 2011, the gold price was trading below USD1,400. On this metric real yields would have to fall back below -1.5% to justify current gold prices.

Even if we compare gold prices with the total return performance of 10-year TIPS, which adds in the impact of inflation, gold prices are still deeply overvalued. The current fair value is around USD1,700.

The only time we have seen gold rise in the face of elevated real bond yields was during the 2003-2007 period, which saw a broad-based repricing of commodities in response to booming Chinese growth and soaring global liquidity. Today, global commodity demand looks to be declining as shown by the fall in the Bloomberg commodity complex, while US money supply is teetering on contraction for the first time on record. These are not the conditions under which we should expect a sustained gold rally.

TIPS Offer A Better Risk-Reward Outlook

We would likely need to see real bond yields decline sharply to justify current gold prices. Over time I expect this to happen, and I would not be surprised to see real 10-year yields back below zero by the end of the year (see ‘TIP: The Great Monetary Reversal Has Begun‘). However, investors are likely to be better off investing in TIPS themselves. Depending on the maturity, TIPS yield around 1-1.5% and will generate income in line with inflation, all but guaranteeing positive real returns. This is not something that can be said of gold, which is also much more volatile than TIPS.