To live like a super-spy, you will need a lot of money! Aston Martin is not a cheap car, and drinking Vodka Martini also has its price. Of course we are not writing about the price of being a Bond, but about the bond prices. It's maybe a little less exciting, but it is probably closer and surely more lucrative for you.
Simply put, a bond price is the sum of money investors need to pay for the bond. Initially, the price of most bonds is typically set at face value (the sum of money that is repaid at maturity). However, bonds frequently trade at prices that are different from their face values. Why is that?
Bond prices are publicly-traded securities, so their prices will constantly fluctuate due to the shifts in supply and demand. There are many determinants of bond prices – such as the coupon rate, the level of face value, a time to maturity, a number of coupons, a credit rating of the issuing government or a company, having extra attributes like embedded options, etc. – but the key factor are changes in the interest rates and bond yields.
Generally, a bond’s price moves inversely to the interest rates’ moves, which means that when interest rates go up, bond prices fall, while when interest rates go down, bond prices rise. This mechanism is easy to grasp. When prevailing interest rates are higher than at the time of issuance of the existing bonds, new bonds are likely to be issued with higher coupon rates, making the old or outstanding bonds generally less attractive. As demand for them weakens, prices go down. And when the market interest rates decline below the bond’s coupon rate, the bond becomes more attractive for investors (it offer a better yield than other available alternatives), so its demand goes up, pushing its price higher.
Bond Prices and Gold
OK, we know now what are the bond prices. But what is their relationship with gold? In theory, gold and bond prices should be positively correlated. The first reason is that both bonds – we mean here the U.S. Treasuries – and gold are perceived as the safe-haven assets. So, when the risk appetite decrease, investors can shift their funds from the stock market into bonds and precious metals.
Second channel operates through the bond yields. But you first have to understand the inverse relationship between the bond prices and bond yields. You see, bonds are priced to yield a certain return to investors. This return – the yield on a bond – is expressed as an annual percentage, determined mainly by the price the buyer pays for it. So, when the market interest rates go down, bond prices go up. And bond yields declines. If you pay $100 to get $10 in coupon payments, your yield is 10 percent (10/100). But when you have to pay $110 to get $10, the yield declines to 9.1 percent (10/110). And when you have to pay $90 to get $10, the yield rises to 11.1 percent (10/90).
Now, we should expect negative correlation between the price of gold and bond yields. This is because when the bond yields decline, gold looks more attractive. With dropping yields that other assets bring, the opportunity costs of holding gold, which does not bear any yield, also go down. Hence, the negative correlation between bond yields and gold prices implies the positive correlation between gold price and bond prices.
And this is exactly what the data shows. As you can see in the chart, there is a clear negative correlation between the gold prices and the bond yields (indexed by inflation). Actually, the lines look like the mirror images of themselves. It suggests that real interest rates are a strong driver of the gold prices.
Chart 1: Gold prices (yellow line, left scale, London P.M. Fix, in $) and the bond yields (red line, right axis, 10-year US Treasuries indexed by inflation, in %) from January 2003 to July 2019.
If you are still not convinced, we insert the same chart but with the bond yields inverted (which mimics the bond prices that are inversely related to the bond yields). As you can see, now both lines are strongly aligned, which reflects a strong positive correlation.
Chart 2: Gold prices (yellow line, left scale, London P.M. Fix, in $) and the bond yields inverted (red line, right axis, 10-year US Treasuries indexed by inflation, in %) from January 2003 to July 2019.
Bond Prices and Silver
And what is the link between the bond prices and silver? Given the strong correlation between gold and silver, we should expect very similar relationship between the silver prices and bond yields and prices. However, as the chart below shows, the correlation between the price of silver and the bond yields seems to be somewhat weaker.
Chart 3: Silver prices (blue line, left scale, London Fix, in $) and the bond yields (red line, right axis, 10-year US Treasuries indexed by inflation, in %) from January 2003 to July 2019.
Indeed, let’s display for clarity the same chart but with the bond yields inverted (which mimics the bond prices that are inversely related to the bond yields). As you can see, both lines are less aligned than in case of gold, which reflects a weaker correlation.
Chart 4: Silver prices (blue line, left scale, London Fix, in $) and the bond yields inverted (red line, right axis, 10-year US Treasuries indexed by inflation, in %) from January 2003 to July 2019.
It is somewhat surprising, but not very much. After all, silver is not the pure monetary asset like gold, but also an industrial metal. Silver often lags behind gold, just to transforms at one point into a high-flying asset, catching up with gold.