As Gold Loses Grip On $2000, Further Losses Await

Gold prices have once again lost their grip on the $2,000 level, with the reversal from the May 5 peak erasing two months of gains for the metal. As I argued earlier this month in 'Gold Hits New All Time Highs, Don't Expect Them To Last', the rally in gold prices is not backed by the fundamentals. Since then, the metal has seen a downside reversal, putting the short-term focus on the February lows around $1,800. Below here would open up a move down to range lows just above $1,600. While this may seem unlikely, the metal's fair value continues to decline due to rising real bond yields and falling industrial metals prices, suggesting downside risks are rising.

Rising Real Yields And Falling Industrial Metals Prices Continue To Undermine Gold's Fair Value

Gold has finally begun to succumb to the intensifying pressure of falling inflation expectations and rising interest rate expectations, which has seen 10-year inflation-linked Treasury yields back towards multi-year highs. While gold bulls have sought to dismiss this rise in real yields due arguments such as central bank gold buying and instability in the US regional banking system, there is no escaping the importance of real bond yields as they represent the opportunity cost of holding the zero-interest bearing metal.

Depending on the time period, the particular real interest rate, and whether we use actual or inflation-adjusted gold prices, the correlation between real yields and gold prices has been exceptionally strong. In recent articles I have looked at the correlation between 10-year inflation-linked bond yields and the inflation-adjusted gold price. The reason being that rising consumer prices gradually raise the fair value of nominal gold prices. Since 2006 the r-squared between the inflation-adjusted gold price and 10-year US inflation-linked bond yields has been 0.66, and this figure was as high as 0.75% in 2021 before the surge in real yields. Based on this correlation, the fair value of gold currently is now around $1,400.

An even greater degree of gold overvaluation is seen when comparing nominal bond yields with the ratio of gold over industrial metals prices. The r-squared between these two variables has been 0.82 over the past two decades, and the current fair value gold price based on this correlation is around $1,000. If we combine the two fair value indicators this gives us a fair value for gold of around $1,200, and the degree of overvaluation is over four standard deviations from its mean.

If The Fed Keeps Rate Elevated, Look Out Below

I should note that gold's fair value can move rapidly, and I expect it to move higher over the coming years due to three factors; positive inflation, falling bond yields, and rising industrial commodity prices. However, based on current real yields and industrial commodity prices, gold is extremely overvalued.

Note also that the real 10-year bond yields used to calculate gold's fair value already factor in aggressive interest rate cuts. Interest rate markets are pricing in 173bps in rate cuts by end-2024, but with stocks having reversed their recent losses and headline CPI remaining far above target, rate risks are heavily weighted to the upside. Any bearish steepening in the US yield curve would further undermine gold's fair value, raising the risk of a crash down to $1,600.

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