What you need to understand about investing in gold is that you’re not really investing in gold. You’re investing against the U.S. dollar. It’s not that gold goes up, it’s that the value of a dollar goes down.
Actually, it’s even more subtle than that. What you’re doing is you’re betting against the interest rate on the dollar. I know this sounds odd, but any currency you carry around in your wallet has an interest tied to it. That’s essentially what the currency is—that rate—and it’s the reason why anyone would want to use it. Gold can be seen as the way to keep all those currencies honest.
People mistakenly believe that gold is all about inflation. That’s not quite it, but high inflation is usually very helpful for gold. What gold really likes is to see is very low real (meaning after inflation) interest rates. Gold is almost like a highly-leveraged short on short-term TIPs.
Here’s a good rule of thumb. Gold goes up anytime real rates on short-term U.S. debt are below 2% (or are perceived to stay below 2%). It will fall if real rates rise above 2%. When rates are at 2%, then gold holds steady. That’s not a perfect relationship but I want to put it in an easy why for new investors to grap. This also helps explain why we’re in the odd situation today of seeing gold rise even though inflation is low. It’s not the inflation, it’s the low real rates that gold likes.
[via maverick@investwise]
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