Why There’s More to Gold’s Rally Than Inflation Fears
(Bloomberg) -- Gold rallied to a record high and gold futures touched $2,000 an ounce as financial markets digested the havoc caused by the coronavirus pandemic. And that breathed new life into the old question of why investors still bother with what’s likely the most primitive form of money in their portfolios. Bullion is best known as a time-honored haven from inflation, but there’s more to its appeal, and plenty of conflicting forces at work that can excite commentators and investors.
1. Is gold an inflation hedge?
The short answer is yes, and no. Research suggests gold’s purchasing power remains relatively stable over very, very long periods. The amount of bread purchased by an ounce of gold has remained relatively stable since the age of Babylon. But on a less-cosmic time frame, the answer isn’t as certain. Since late 2018, the metal rallied 70%, yet inflation has remained subdued, and is below the level targeted by most of the world’s big central banks. So there’s clearly more that just inflation fears at work.
2. So inflation doesn’t matter near term?
It does, but primarily as a component of expected real rates, the closely watched measure of interest rates adjusted for inflation. When interest rates fall, gold becomes more attractive because the opportunity cost of leaving money in the metal -- which yields no inherent investment return -- decreases. At the same time, as inflation rises, the reason for owning bullion in the first place strengthens. The market’s favored gauge of real rates are yields on the U.S. Treasury Inflation-Protected Securities, which provide investors built-in compensation for the effects of rising price levels. And breakeven inflation rates -- measured by the gap between nominal yields on Treasuries and TIPS yields -- are a proxy for future inflation. As the U.S. Federal Reserve set a path to keep monetary policy uber-easy to fight the effects of the pandemic, breakeven rates rose, helping to drive real rates near historic lows.
3. So all we need to forecast gold is real yields?
Not so fast. The reason U.S. real rates matter for gold, is that they influence the strength of the dollar -- the single biggest contributing factor in gold’s tick-by-tick price moves, based on an analysis of historic price correlation. And for the dollar, it’s not the absolute level of real rates that matters, but rather how they compare with those of other currency peers. And other things influence the dollar too, like geopolitical risk, elections and the outlook for economic growth. Some traders say the dollar has been losing ground to gold this year in part because the Fed has been purchasing so much of the U.S. government’s record debt sales -- potentially debasing the greenback and dimming its allure as a haven.
4. So gold is the anti-dollar?
Most of the time yes. Except when it’s not. In times of acute stress, both gold and the dollar tend to act as havens -- and they become positively correlated. In fact, during every U.S. recession since the 1980s, the normally stable link between the metal and the currency inverted. And that’s exacerbated when the epicenter of the crisis is in other parts of the world, like during the early phases of the coronavirus crisis, or the euro zone sovereign debt crisis.
5. So essentially, gold isn’t correlated to anything?
That’s often seen as one of its strengths, as it lowers the volatility in a multi-asset portfolio. But again, it’s only part of the story. In normal times, gold’s moves are inversely linked to the dollar. In times of stress, though, it can take the opposite side of whatever the biggest fear in financial markets is. Analysis by Bloomberg showed the metal’s relationship with a range of assets becomes more inverse as volatility in the counter asset increases. That’s what makes gold a haven, that it protects against generalized uncertainty, rather than any specific market risk.
6. Is that what happened in the pandemic?
Yes, but there’s just a little more to it. Gold can also be considered a Veblen good, which means that as its price goes up, it can become even more desired. When gold rallies, it excites commentators and investors -- so more is written about it, which can lead to more money flowing in. At those times, rallies can become self-perpetuating. That might help explain gold’s propensity to trend -- its autocorrelation, where one period’s returns are echoed in the next, is strong. Regression analysis of price moves against those a year earlier shows a stronger echo for gold than the same measure for the S&P 500 stock index or commodities such as oil and copper.
The Reference Shelf
- A Bloomberg story explains how the virus has unleashed a torrent of forces that’s fueled a rally in gold.
- A 1998 report from economist Stephen Harmston published by the World Gold Council explores the metal’s allure as a store of value.
- A QuickTake on the debate about investing in gold.
- An outlook for what might propel gold higher in 2020.
- A column on the link between real interest rates and gold by Bloomberg’s John Authers.
- A Macro View column on gold’s correlation with the dollar and a study on how its relationships with assets changes over time.
- An e-book version of the 1852 classic “Extraordinary Popular Delusions and the Madness of Crowds” by Charles MacKay.
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