Where’s the fire fueling gold?

Gold (COMEX:GCZ13) took quite a beating in September, bucking its seasonal average monthly return of 2.3%. The political battle between President Barack Obama and Congress, China’s Golden Week, and India’s gold import restrictions likely weighed on the metal.

September’s correction only adds to the negative sentiment toward the precious metal. The assumption from many market pundits is that gold is no longer attractive as an investment. With rising rates and continuing low inflation, U.S. investors believe they have a solid case for selling their holdings.

However, this could be a premature assessment, causing these bears to potentially lose out on a lucrative position.

Allow me to use an ice cube to explain.

One of the strongest drivers of the Fear Trade is real interest rates. Whenever a country has negative-to-low real rates of return, which means the inflationary rate (CPI) is greater than the current interest rate, gold tends to rise in that country’s currency.

Our model tells us that the tipping point for gold is when real interest rates go above the 2% mark.

Consider the ice cube, which shows how new equilibriums can have significant effects. At 31 degrees, H2O is a solid chunk, but when the temperature increases, the mass slowly begins to turn into a liquid. Above 32 degrees, ice changes form from solid to liquid, but it’s still made of hydrogen and oxygen.

Because money is like water, when many other economic dynamics, such as population growth, urbanization rates and changes in government policies, reach their tipping point, the velocity of money tends to be altered.

As global investors, we watch for changes in these trends to know how to invest in commodities and markets, find new opportunities and adjust for risk.

So, how close to gold’s tipping point are we? In other words, what is the real interest rate today? As you can see below, Treasury investors continue to lose money, as the 5-year bill yields 1.41% and inflation sits at 1.5%. This is nowhere near the 2% mark.

I would be worried about gold if real interest rates solidly crossed the 2% threshold for an extended amount of time, because it would have a dramatic effect on gold as an asset class. In a high interest rate environment, gold and silver lose their attraction as a store of value.

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