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Chart of the month: Bond yields and foreign exchange rates

Bond yields and foreign exchange (FX) rates are important market drivers of precious metal prices and the returns investors can generate on these investments. 

In this blog post, we are going to look at movements in US and Australian 10-year government bond yields and in the AUDUSD FX rate across the past decade and how they are relevant to gold.

The below chart shows the movements in US (red line) and Australian government (black line) 10-year bond yields from 1999 to 2019.   

 Source: The Perth Mint, Reuters

As you can see, yields have fallen significantly, and are now 88% lower in Australia and 90% lower in the US relative to where they were in 1999. Most of these declines were experienced in the years after the Global Financial Crisis (GFC) hit. 

This fall in bond yields has been one of the factors that has driven the gold price from under USD 300 to more than USD 1,700 per ounce over this time period. Decreasing yields reduce the opportunity cost of investing in gold as the future returns investors can generate from bonds decline when yields fall. 

The second chart looks at both bond yields again, but instead of plotting them individually, it shows the differential, or the spread, between the two. This is the black line on the chart. The chart also displays movements in the AUDUSD over the same time period. 

 Source: The Perth Mint, Reuters

Note the correlation between fluctuations in the yield spread and the AUDUSD FX rate.  

Whenever the black line is rising, it means that the spread between 10-year yields in Australia and the US is growing (meaning bond yields in Australia are getting higher relative to those in the US). This has tended to correlate with a rising Australian dollar. 

Whenever the spread declines (meaning bond yields in Australia are getting closer to those in the US), you tend to see downward pressure on the FX rate, with the AUDUSD falling.
The chart displays two key trends over the past 20 years.

From 1999 to 2011 the bond spread increased as the gap between the yield on Australian government bonds relative to the yield available on US government bonds grew. The Australian dollar appreciated alongside this lift in spreads, rising from USD 0.64 in early 2000 to USD 1.10 by 2011.

Since 2011, bond spreads have declined from almost 3% to barely zero today. The Australian dollar has been in a downwards trend in comparison to the US dollar over this time period and is now back at almost the same level it was at the turn of the century.  

Indeed, at one point in early 2018, the spread between Australian and US 10-year government bonds went negative, meaning you earned more by lending to Washington rather than Canberra. 

From an Australian investor perspective there are two key takeaways.

The first is that very low bond yields (in both countries) are likely to be a feature of the financial landscape for a long time given that even 30-year bonds are yielding less than 1.50%. This is likely to support gold demand for years to come. 
The second relates to the AUDUSD exchange rate. If it were to follow the spread in yields going forward, then we could see further downside in our local currency as it continues to look expensive based on this metric. Whilst there are no guarantees, were this to happen, it would boost the Australian dollar price of gold. 

From a risk management perspective, many of the Australian investors we deal with at The Perth Mint are happy to have their exposure to gold unhedged in Australian dollars. This is because they see it as currency diversification for their overall wealth, given they typically earn their income in Australian dollars and have exposure to Australian real estate, shares and cash in their portfolio. 

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