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Welcome back. I own no gold, other than a pair of cufflinks my dad gave me. My wedding ring is platinum. But the topic is unavoidable, especially when the topic on everyone’s mind is inflation. So here goes.
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A hedge against what, exactly?
Wednesday’s piece on Japan in the 1980s was, in a sense, about regime change. The idea was that a big shift in Japanese monetary policy, fiscal approach and corporate culture brought about an asset price bubble and permanently reset all sorts of economic relationships. The question is whether the present unleashing of simultaneous easy fiscal and monetary policy, and the change in the Federal Reserve’s attitude towards inflation, means the US is heading for a similar regime change?
Because a main risk of this potential regime change is, by consensus, high inflation — which would likely cause a correction in stock and bond markets — my mind turned to hedging. Readers’ minds are in a similar place: I have received a number of emails asking where the safe assets are.
Gold is an obvious candidate; it is often touted as an inflation hedge. But that is too general. Gold has one of the most stable relationships to economic fundamentals of any asset. It moves inversely to real interest rates with great regularity, especially in recent years (all chart data from the Fed):
The yield on inflation protected 10-year Treasuries (the blue line) is the standard proxy for real interest rates, or the inflation-adjusted cost of money, which is currently negative.
Gold (yellow line, note that the scale is inverted) has followed real rates, slavishly but in reverse, for 15 years, rising when real rates fall and falling when they rise. There is a simple reason: the real return on money is the opportunity cost for holding gold, an asset that yields nothing. Nominal rates have been rising lately, driven up almost solely by inflation expectations, so gold has cut an uneven but basically sideways path in recent months.
Holding gold will do you no good, judging by the above chart, if the new economic regime increases inflation, but also manages to stimulate real economic activity and real rates. For gold to work, you have to get the inflation without any real growth pay-off (you may have an economic pay-off in the sense of making debt burdens lighter on both sovereigns and households, even without real economic growth, but that is not what fans of monetary/fiscal co-ordination tend to claim they are after).
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 feel unstable might make investors want something stable in their pockets, no?
Below is a picture of the longer-term relationship between gold and real rates. I have used a different proxy for real rates here, though, because Treasury inflation-protected securities are a relatively new phenomenon. Instead I have used 10-year yields minus the annual rate of CPI inflation. This renders a slightly more volatile series, but checking it against Tips renders a pretty good match. I’ve also left the inflation rate in (in grey).
The period of most interest here is the 1970s, where two huge jumps in inflation drove real rates down hard. Zooming in on those years:
What is compelling here is that the relationship holds (real yields down, gold up) but it is not very stable. When real yields crashed the first time between September 1972 and December 1974, dropping by over eight percentage points, gold rose by 179 per cent, a very nice return in a period when stocks lost a third of their value. But when inflation came through the second time, between 1978 and 1980, gold was spectacular. On a significantly smaller fall in real yields, it rose 238 per cent.
My tentative interpretation is that gold looked better and better to investors as inflationary instability persisted, leaving investors progressively more anxious.
But then came the 1980s, and Paul Volcker’s Fed. Inflation looked like it had been put permanently back in the bottle. And under stable inflation, the real-rates gold relationship was cut adrift, to a degree. There was a large decline in real rates between 1985 and 1990, a swing of over six points, but it happened in a gradual and orderly way, against a background of relatively tame inflation and inflation volatility. Gold rose by only 25 per cent. Again, the violence of the times, and how beaten up investors were feeling, seemed to matter to gold — not just the real yield.
And the next big rally for gold came, of course, in the run-up to and the aftermath of the great financial crisis, a period of volatility of all sorts.
As true students of the metal will have determined by now, I am no gold bug. My modest suggestion is only this: the link with real yields is persistent but varies in strength through time. An economic regime change, such as the one many people are going through now could once again change the gold/real rates relationship, which has seemed so consistent in recent years. Hedge carefully, friends.
I received several emails about my Japan piece on Wednesday from readers who worked in Japanese finance in the late 1980s, many commenting on how much today’s environment reminded them of that era. Here is a particularly representative sample, from James Bogin, who worked as an analyst in Tokyo in 1987:
“Japan was hit worse than most by the oil shock in the 1970s. They had a weak currency, and oil imports were 10 per cent or more of GDP. They ran a very loose monetary policy for a long time, leading to a stock market boom in latent asset stocks . . . With massive liquidity flowing . . . companies would issue stock convertible bonds with warrant 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 (“latent assets”) is familiar bull market stuff. So is the proliferation of tricky instruments (warrants, Spacs). What strikes me as particularly reminiscent of today is companies raising money “because it’s cheap, and we can”. Hello, AMC.
One good read
I came across this on Wednesday, from way back in 2018. It struck me as so true that I laughed out loud. What trait is the key for an up-and-coming employee in law, finance, consulting and the like? It may be personal insecurity.