I recently wrote about what drives gold prices. In short, gold prices rise when real interest rates are falling, low or negative.
While gold is often viewed as a safe haven and a hedge against inflation, it doesn’t exist in a vacuum.
Gold competes in many ways with US Treasuries as a safe haven. If investors can receive a positive real return on US Treasuries they are less likely to use gold – which provides zero yield – as a safe haven. The higher the real yield, the worse non-yielding assets look in comparison.
In contrast, when real yields on US Treasury bonds are negative, investors actually lose by holding them. A zero-yield actually becomes more attractive at that point.
As it happens, falling, low or negative real yields tend to occur during periods in which the economy and currency is under tremendous stress and/or savers are purposely being repressed. In the US, real interest rates were falling, low or negative during the 1970s, from 2000-2011 and after 2015. The economic backdrops for each period weren’t identical, yet gold rallied during each of these periods.
Conversely, when US real interest rates were firmly positive gold prices declined, such as from 1980-2000. Why? Because there were plenty of better options for those looking to preserve their wealth. There is less incentive to hold something with no yield when an investor can beat inflation using a risk-free asset.
The Problem With Gold
Many investors and market pundits look at gold as a catch-all hedge against everything bad in the world. Inflation, deflation, war, famine, market crashes, you name it. And then they argue gold is useless when it doesn’t behave accordingly.
For example, look at gold’s performance during the past two market crashes – 2008/2009 and 2020. Gold positions were liquidated alongside every other asset (including US Treasuries, by the way). Margin calls and a spiking dollar are the natural enemy of gold prices. People point to these episodes as ‘proof’ that gold doesn’t do what it’s supposed to do.
However, those who held tight knowing what was to come soon did well. Like clockwork, both crashes were accompanied by economic disaster and followed by monetary mayhem that crushed yields. With 10yr US Treasuries currently hovering around 53bps, it is highly unlikely they will provide a positive real yield once we get through the immediate crisis.
Right now, we’re in the midst of a deflationary collapse. However, inflation expectations are beginning to rise as it is becoming increasingly clear that current policies meant to combat that deflation may ultimately create inflation. Almost unbelievably, consumer inflation expectations are higher now than they were in January, when the US was experiencing the “best economy ever”.
Similarly, the 10yr breakeven inflation rate is steadily recovering from crisis lows and UK inflation expectations are at a 7 year high!
Consumer Inflation Expectations
Source: Trading Economics
10 Year Breakeven Inflation Rate
Source: St Louis Fed
UK Inflation Expectations
Source: The Telegram
Inflation expectations are rising not just because money supply is expanding at record rates. They are rising because people are beginning to understand that much of the world has opened the door to direct government transfers to citizens and businesses.
People have been kept whole through the COVID-19 crisis via government transfer payments directly into their bank accounts. While a significant portion of these payments were initially saved, with the economy opening up it will make its way into the real economy. This contrasts greatly from stimulus of the past, which was mainly directed at supporting the banking system with new liquidity becoming trapped and never finding its way to the real economy.
Governments are now debating about how to wean citizens off these monthly payments, but there is a reasonable probability that this backfires. Imagine the deep hole we’d be in if those payments weren’t made. Like QE1, this initial toe-dip into helicopter money will prove difficult to end. People are too broke, society is too indebted and jobs will take years to come back. Moreover, now that direct payments are openly acceptable many politicians won’t hesitate to take advantage and spend their way to re-election.
At the same time, governments are now also directing supporting commercial credit via Special Purpose Vehicles in which they are the equity owners. This creates another avenue for money creation in the real economy, by removing typical barriers to corporate lending (i.e. credit adjudication).
Most importantly perhaps, because of excessive debt levels politicians have the motivation to generate inflation – and now they have the tools. In an interview with “The Market“, investment strategist Russel Napier, a 25 year industry veteran, makes the following case:
I make two key calls: One, with broad money growth that high, we will get inflation. And more importantly, the control of money supply has moved from central bankers to politicians. Politicians have different goals and incentives than central bankers. They need inflation to get rid of high debt levels. They now have the mechanism to create it, so they will create it.
Give someone a hammer and suddenly everything looks like a nail. In other words, governments now have new tools for getting money directly into the hands of companies and citizens, bypassing the banking system.
Ultimately, Napier sees inflation rising to 4% next year:
I see 4% inflation in the US and most of the developed world by 2021. This is primarily based on my expectation of a normalization of the velocity of money. Velocity in the US is probably at around 0.8 right now. The lowest recorded number before that was 1.4 in December 2019, which was at the end of a multi-year downward trend.
And what does he think would cause money velocity to rise?:
The money banks are handing out today is going straight to businesses and consumers. They are not spending it right now, but as lockdowns lift, this will have an impact. My guess is that velocity will normalize back to around 1.4 sometime next year. Given the money supply we have already seen, that would give you an inflation rate of 4%. Plus, there is no reason velocity should stop at 1.4, it could easily rise above 1.7 again. There is one additional issue, and that is China: For the last three decades, China was a major source of deflation. But I think we are at the beginning of a new Cold War with China, which will mean higher prices for many things.
This is a long way of saying that the world is likely to experience financial repression – i.e. negative or very low real interest rates – for the foreseeable future. This is a constructive environment for gold.
Why Did Gold Fail Japan?
Some people point to Japan after its bubble imploded around 1990 as evidence that gold failed as protection against calamity.
From 1990-2000, gold (priced in Yen) declined about 50%, alongside a collapse in the Nikkei and Japanese real estate prices. From this perspective, gold clearly didn’t hedge against economic disaster.
Gold Price in Yen
Source: Gold Price
However, as I previously stated, gold should not be viewed as a catch-all hedge against calamity.
By looking at real interest rates you can see why gold performed the way it did. Between 1990 and 2000, real interest rates in Japan were very high, as you can see in the chart below.
Japanese Real Interest Rates
Source: World Bank
Gold failed Japan because during the 1990s because people misunderstood gold’s investment characteristics.
Gold is a safe haven that competes with other safe havens. When something more attractive comes along – perhaps because it pays a comparably high real yield – investors move away from gold.
So while some might say gold ‘failed’ Japan during the 1990s, I would argue it performed exactly as it should.
This article is a long way of making what seems like a simple point: investors should be positive on gold when real yields are falling, low or negative.
Right now, governments around the world – including America – have a heavy incentive to suppress yields while allowing inflation to rise. And they now have better tools to do this.
The current environment remains supportive for gold for the foreseeable future.
Disclosure: I am/we are long KGC, GOLD, AEM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am also long gold using TSX-listed ETFs.
This is not advice. Please contact a registered investment professional to discuss your personal financial circumstances. While every effort was made to ensure accuracy, the information in this article contains no warranties with regards to accuracy.
Source: Seeking Alpha