How Negative Real Rates Should Impact Gold (and Possibly Bitcoin)
We argue that investors should focus on negative real rates as a driver for non-productive assets, like gold and bitcoin, not negative nominal rates, which is the focus of much of financial journalism today. This is an important distinction because negative real rates are increasingly becoming the norm around the world, even in the US and the UK, which have positive nominal rates. Negative real risk-free rates make non-productive assets relatively more appealing compared to cash alternatives.
If you’ve consumed even the slightest amount of financial information over the past few months, undoubtedly you’ve read one or more headlines that refer to negative bond yields. These are bonds, issued as obligations of both sovereign nations and corporations, that promise to pay purchasers back less in the future than is borrowed today. Negative yielding bonds continue to grow in size and as of writing, there is $17T worth of negative yield bonds, mostly issued in Japan and Western Europe, according to data compiled by Bloomberg.
While negative-yielding bonds are an abrogation of the implicit covenant between lender and borrower, that is that borrows pay lenders interest, we think this misses the mark in a subtle but important way. We believe that understanding the nuances between nominal and real rates in the context of the current global economic situation may better inform investors, and help them more easily navigate the road ahead.
Nominal vs Real: What’s the Difference?
When we usually talk about interest rates (or other rates of return), we typically refer to nominal rates. This is the type of rate that is referred to in headlines like “Federal Reserve cuts interest rates by 0.25%” or “the stock market fell 1% yesterday.” Nominal rates are the returns in terms of money, which incorporate inflation. Real rates are returns in terms of goods and exclude the (usually negative) impact of inflation. Expressed formulaically, Nominal Rate = Real Rate + Inflation or conversely, Real Rate = Nominal -Inflation. Graphically, it may be interpreted like this:
Why is this Important?
The reason this is important is that we’d argue investors should be focused on real returns as a hurdle, how to use their dollars to increase purchasing power, not nominal returns. Real returns are something within their control, while the monetary aspect that contributes to nominal returns, inflation, is not. While inflation in the US is a memory as distant as disco and polyester clothing (and still not a current fear as measured by market data) we are currently in or entering a very unique time in financial history as judged by both nominal and real rates.
What are Risk-Free Assets Telling Us?
Obligations issued by the US Treasury (bills, notes, bonds, inflation-protected securities) have a unique distinction within finance, that of the notion of a “risk-free” return. The idea, whether you subscribe to it or not, is that the US government is among the least risky issuers for a variety of historical, political, social, and economic reasons, and therefore their obligations can be deemed free of credit risk.
The US Treasury issues numerous types of obligations but we’re going to focus on two: 10 year Treasury bonds and 10 year Treasury Inflation-Indexed Securities (TIPS). The relationship between nominal and real rates can easily be decomposed by yields on these two instruments, with 10y US Treasuries representing nominal rates and 10y TIPS representing real rates. Graphically, here are their constant maturity yields since 2003:
The difference between the two yields (nominal minus real yield) is inflation expectations (a market-based measure of expected inflation), also known as breakevens. I’ve plotted inflation expectations vs a measure of actual inflation, core CPI y-y growth.
What are TIPS a Saying about Purchasing Power
Back to our definition of real rates, returns excluding inflation impacts, when we look at TIPS, we can also think of TIPS yields as the risk-free increase in purchasing power available to investors. Said slightly differently, TIPS yields are the rate at which investors can be reasonably assured to increase their purchasing power without risking the loss of capital.
The implications of the last sentence and negative real rates are profound — it means that in order to have a chance of keeping or gaining purchasing power with cash balances, those balances have to be invested in a non-risky asset (real estate, stocks, higher risk debt, etc). By this mechanism, negative real risk-free rates “force” holders of cash into other asset classes. To borrow a popular phrase in financial journalism, negative real rates punishes savers. While most asset classes already have positive expected rates of return, non-productive assets (assets which do not produce their own cash flows like art, gold, raw land, collectibles, bitcoin, etc) should see the biggest incremental benefit from the move out of cash.
Said differently, when real rates are 0% and cash becomes non-productive, investors should be ambivalent about holding a portfolio of cash vs other non-productive assets. When real rates are negative, investors are incentivized to hold portfolios of other non-productive assets over an asset which is actively destructive to purchasing power.
Nice Theory, Show Me Some Data
How does this hypothesis fit with the data? Looking at the change in real yields with the change in the price of gold going back to 1997 we think the following scatter plot, a chart we’ve shown in the past, is instructive. The way we interpret this is that declines in real yields have strongly (t Stat) explained about 20% (R2) of the positive move in the price of gold (inverse correlation).
This distinction of real yields is important because while many countries still have positive nominal rates on their sovereign debt, real rates are increasingly becoming the norm around the world. This includes both the US and the UK. 10y TIPS currently yield 0.13% but hit -0.09% at the end of September. 10y UK Index Linked Gilts currently yield -2.97%. Using real rates as a bar, the amount of debt with negative yields would be significantly understated at $17T.
What Does This Mean For Bitcoin?
Bitcoin, like gold, is another non-productive asset, albeit one without the longevity and societal acceptance of gold. While we believe the overwhelming majority of bitcoin’s price movement is idiosyncratic in nature, there is no reason that we can’t apply the real rates lens to this asset. Statistically speaking, however, the correlations between the prices of gold and bitcoin are quite low (90-day rolling correlations range from -0.3 to +0.3) and observationally, bitcoin does not react intra-day to macroeconomic news the same way other asset classes like gold, treasuries, and bonds do. We think the fact that bitcoin and other digital assets are dominated by other forms of risk is a benefit to the asset class: it adds diversification benefits to multiasset class portfolios and offers the ability to generate alpha for skilled digital asset portfolio managers. Plus, who needs a 2x gold beta when there are already 2x and 3x levered gold ETFs? We think it’s important for Bitcoin to retain its unique market properties for traditional managers to see its benefits.
To find out how we help financial institutions and investment managers navigate this fast-moving industry, reach out to us here.
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