Gold prices have increased by 14% this year so far





Gold prices have been on a tear this year. The precious metal has returned 14.0% this year, despite a small pullback since September. As of November 13, gold was trading at $1463 per troy ounce, in the spot market.





Gold prices have been steadily increasing since the start of 2016, after a massive plunge in the bullion saw since 2011. Since the start of 2016, gold has returned 37.4%.

A major factor that has helped drive gold prices in the past three years or so is the gradual decline in real interest rates in the US.





Real interest rates are considered to be one of the biggest drivers of gold prices. Real interest rate is interest rate minus inflation.





Higher interest rates push gold prices down. This is because gold does not yield any money if you store it. In fact, you have to pay storage costs, but that's beside the point.

If interest rates rise, investors would prefer interest-yielding assets, which would then be more attractive due to higher rates. If interest fall, however, investors then flee to gold as interest-yielding assets are less attractive.





Gold is considered as a good hedge against inflation. Hence gold prices increase with inflation rates and the other way around.





As a result, real interest rates, which is interest rates minus inflation tend to be a good indicator of gold's direction. Lower real rates support gold prices.

Since real interest rates have been steadily declining in the US since 2015, gold prices have held up quite well in that period.













Real interest rates have slowly declined in the past few years





The graph above shows that while the direction of real interest rates has had a big say on gold prices historically, its impact on gold has reduced over the years.

That said, over the last year, the correlation between gold and real interest rates has been -0.51, which is still pretty high.





The correlation coefficient can range between +1 and -1. If it is closer to +1, it means that the two variables move in lockstep. If it reads -1 then they move in the opposite directions, proportionately. A correlation of 0 means the two variables move in random directions.





In the graph above, monthly movements of gold and real interest rates were considered. The yield on the 10-year US Treasury was taken as a proxy for interest rates, and year-over-year CPI inflation in the US was used to calculate real interest rates.





While the correlation between gold and real interest rates is less negative relative to historical levels, gold's negative correlation with the dollar has also mellowed down a bit.









The stronger dollar has not derailed gold's rally this year





This year, the dollar has strengthened to an extent. This has not derailed gold's rally. A stronger dollar has typically led to a decline in gold prices in the past.





Since 1973, the correlation between gold and the dollar index has been -0.34, considering monthly movements. Over the last 12 months, not only has the correlation been positive it has been as high as +0.45, which is quite unusual.





There has been another major factor that has caused gold to rally this year. While stocks have performed well recently, the CBOE volatility index, which is a measure of risk in the stock market has risen.





This was mainly on the back of geopolitical uncertainties throughout the year. When stock market uncertainty increases, investors flee to safe havens like Treasuries and gold.





What has driven gold's rally this year?





However, since Treasury yields have been so low this year, investors have been put-off by it. This naturally meant that gold got more attention, especially since real interest rates have been declining.





The correlation between gold prices and the VIX index in the last 12 months has been +0.91, which is extremely high. The higher volatility in stocks has been the biggest driver of gold prices this year.





Over the last 10 years, the correlation between the two has been positive, but only +0.24.





Where is gold headed?





Going forward, interest rates are not likely to rise any time soon, with the global economy set to slow down further going into 2020. The dollar might remain strong due to the inflow of foreign money as the US Treasury remains far more attractive than European and Japanese government bonds which have negative yields.





Meanwhile, geopolitical uncertainty remains on the horizon. Increasing risks on this count will send equities tumbling, given lofty valuations, which could support gold prices. A relatively low Treasury yield profile also makes gold more attractive in a risk-off scenario.





Overall there are many bullish cases for gold. A stronger dollar, along with calmer equity markets are looming risks, though. However, from a portfolio point-of-view, it makes a lot of sense to keep some gold in an equity-heavy portfolio.





In the short term though, all else equal, gold prices may not see a major bump. Since 1968, gold has given the least returns, on average, in the first quarter of the calendar year and the best during the fourth quarter.





Its fourth-quarter outperformance has been supported by heavy demand in India, due to the festive season in October and November.