Gold prices tumbled by 7.5 per cent in June. This was the biggest monthly drop since at least 2016. It now trades at $1749 per ounce.
The primary reason for this drop in gold prices was the rise in treasury yield over the past couple of months.
For those who may not know, treasury yield is normally the return on 10-year US government bonds.
This is to say that gold prices and treasury yields move in opposite directions – they are negatively correlated. When treasury yields rise, gold prices tend to fall and vice versa.
ENTER OPPORTUNITY COST
The reason for this has to do with an economic concept called “opportunity cost”. Simply put, opportunity cost is the cost of choosing one option over another.
For instance, if I had Rs 2 lakhs of savings, I could choose to invest that amount in either a fixed deposit at, say, 7% interest per annum or I could choose to invest it in the stock market to earn, say, 15-20% return per annum. Of course, both options come with pros and cons. While fixed deposit returns are “fixed”, stock market returns are volatile.
But suppose I chose to invest in fixed deposit at 7%.
By doing so, I’d be forgoing the return that I would have earned in the stock market – in fact, during a bull market like the one we are witnessing presently, that return (and therefore also the “opportunity cost” of investing in a fixed deposit) could be significantly higher, say, at 30 or 40% if my stock picking abilities are decent.
THE OPPORTUNITY COST OF HOLDING GOLD
In our gold example, the opportunity cost of holding gold is the return I forgo on treasury bonds.
If the yields on treasury bonds rise, then gold becomes “relatively” less attractive compared to earlier when bond yields were low.
So, global investors shift their capital from gold to treasury bonds which puts downward pressure on the price of gold.
Below is the chart depicting 10-year government bond yield versus gold prices in MCX (Multi-commodity Exchange) since 2016.
For investors, this relationship between gold prices and bond yields may help make better asset allocation decisions. Gold futures on MCX, for instance, increased by 19% -- from Rs 44900 to Rs 53445 per 10 gram -- in from April to July 2020. This happened as the US 10-year bond yield reduced from 0.65% to 0.5%.
Post July, when yields rose from 0.5% to 1.45% today, the gold futures on MCX fell from a peak of Rs 53445 to trade at Rs 47200 today – a drop of about 11%. Going forward, gold may show a similar trend in relation to the US 10-year bond yield trajectory as investors react to the relative attractiveness of bond yield versus gold.
OTHER FACTORS IMPACTING GOLD PRICES
It must be noted, however, that this is not the only factor that impacts gold price behavior. There are others such as inflation (which puts upward pressure on gold prices), demand and supply of the bullion, geopolitical factors as well as currency fluctuations -- in India’s case, USD versus INR exchange rate behavior.
The exchange rate has a particularly strong impact on Indian gold prices. A depreciation in rupee may increase the import price of gold in India, even though international price of gold may reduce during the same period.
For instance, even though international price of gold dropped by 7.5% in June (as mentioned at the beginning of this post), its price in India during the month dropped by only about 3.5%, from Rs 49000 to Rs 47300 per 10 grams, because the rupee slipped from 72.86 to 74.82 during the month – making the imported price of gold relatively expensive for the Indian consumer.
An investor must take these factors into account while making asset allocation decisions between gold and other assets.