This article is an on-site version of our Unhedged newsletter. Sign up here to receive the newsletter directly to your inbox every day of the week
Happy to see you again. I don’t own any gold other than a pair of cufflinks my dad gave me. My wedding ring is in platinum. But the subject is unavoidable, especially when the subject that concerns everyone is inflation. So this is it.
Email me at [email protected]
A hedge against what, exactly?
Wednesday’s article on Japan in the 1980s was, in a sense, about regime change. The idea was that a big change in Japanese monetary policy, tax approach and corporate culture caused an asset price bubble and permanently reset all kinds of economic relationships. The question is, does the current outbreak of a concurrent accommodative fiscal and monetary policy and the Federal Reserve’s shift in attitude toward inflation mean the United States is heading for a similar regime change?
Given that one of the main risks of this potential regime change is, by consensus, high inflation – which would likely cause stock and bond markets to correct – my mind turned to hedging. Readers’ minds are in a similar position: I have received a number of emails asking me where the safe assets are.
Gold is an obvious candidate; it is often presented as a hedge against inflation. But it’s too general. Gold has one of the most stable relationships to the economic fundamentals of all assets. It evolves inversely with real interest rates with great regularity, especially in recent years (all graphical data from the Fed):
The yield on inflation-protected 10-year Treasury bills (the blue line) is the standard indicator of real interest rates, or the inflation-adjusted cost of money, which is currently negative.
Gold (yellow line, note the scale is inverted) has followed real rates, slavishly but upside down, for 15 years, rising when real rates fall and falling when they rise. There’s a simple reason: the real return on silver is the opportunity cost of holding gold, an asset that doesn’t earn money. Nominal rates have been rising lately, driven almost solely by inflation expectations, so gold has cut an uneven but mostly sideways trajectory in recent months.
Holding gold will not do you any good, judging by the graph above, if the new economic regime raises inflation, but also manages to stimulate real economic activity and real rates. For gold to work, you need to get inflation without any real growth gain (you can have an economic gain in the sense of easing the debt burden of sovereigns and households, even without real economic growth, but this is not what supporters of monetary / fiscal coordination tend to claim).
I wonder, however, if significantly higher and more volatile inflation would make gold more valuable as a hedge, even if real rates were to rise. High real rates that seem volatile might make investors want something stable in their pockets, right?
Below is a picture of the long-term relationship between gold and real rates. I have used another indicator of real rates here because inflation-protected Treasury securities are a relatively new phenomenon. Instead, I used the 10-year yields minus the annual CPI inflation rate. This makes a series slightly more volatile, but comparing it to Tips gives a pretty good match. I also left the inflation rate in (in gray).
The most interesting time here is the 1970s, when two huge increases in inflation pushed real rates down sharply. Focus on these years:
What is compelling here is that the relationship holds (falling real returns, rising gold) but it is not very stable. When real yields first collapsed between September 1972 and December 1974, falling more than eight percentage points, gold rose 179%, a very good return in a period when stocks lost a third of their value. But when inflation returned, between 1978 and 1980, gold was spectacular. On a significantly smaller drop in real returns, it rose 238 percent.
My tentative interpretation is that gold looked better and better to investors as inflationary instability persisted, leaving investors increasingly anxious.
But then came the 1980s and Paul Volcker’s Fed. Inflation seemed to have been put back in the bottle for good. And in a context of stable inflation, the gold-real rate relationship has been reduced to some extent. Real rates fell sharply between 1985 and 1990, an oscillation of more than six points, but it occurred in a gradual and orderly fashion, against a background of relatively contained inflation and inflation volatility. Gold only rose 25 percent. Again, the violence of the day, and how bullied investors felt, seemed to matter to gold, not just actual performance.
And the next big rally for gold came, of course, on the eve and in the aftermath of the great financial crisis, a period of volatility of sorts.
As real metal students will now have determined, I am not a golden bug. My modest suggestion is just this: the link to actual returns is persistent but varies in strength over time. A change in economic regimes, like the one many people are currently experiencing, could once again alter the gold / real rate relationship, which seemed so constant in recent years. Cover yourself carefully, friends.
I received several emails on Wednesday regarding my article on Japan from readers who worked in Japanese finance in the late 1980s, many commenting on how much today’s environment reminded them of that time. . Here is a particularly representative sample, from James Bogin, who worked as an analyst in Tokyo in 1987:
“Japan was hit harder than most by the oil shock of the 1970s. They had a weak currency and oil imports were 10% or more of GDP. They have long conducted a very accommodating monetary policy, leading to a stock market boom in stocks of hidden assets. . . With massive liquidity flowing. . . companies were issuing bonds convertible into stocks with warrants sweeteners because the interest rates were so low. I once asked a cement company why they raised money, and the answer was, basically, because it’s cheap, and we can. “
Discovering new reasons to value companies at ever higher valuations (“hidden assets”) is a familiar thing in the bull market. The same is true of the proliferation of delicate instruments (warrants, spacs). What particularly reminds me today are the companies that collect money “because it’s cheap, and we can”. Hello, AMC.
A good read
I ran into this on Wednesday, since 2018. It felt so true to me that I burst out laughing. What trait is key for an aspiring employee in law, finance, consulting, etc. ? It can be personal insecurity.
Recommended newsletters for you
Due diligence – The best stories from the world of corporate finance. register here
Marsh Notes – An expert opinion on the intersection of money and power in American politics. register here