Are Higher Inflation Expectations Good For Gold?
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We have a great question here from a subscriber asking about Gold, saying if the market thinks that we’ll get higher inflation and since Gold is seen as an inflation hedge, shouldn’t Gold be moving higher as inflation expectations push higher?
This is such a great question, and something that we’ve had other questions about in the terminal recently as well.
You’re right that Gold has traditionally been seen as an inflation hedge, because it’s a hard asset that keeps it’s value, so as currencies lose value as inflation rises, Gold should not, so it’s seen as a hedge for when inflation goes up.
However, I think there are two very important reasons why Gold is not moving up alongside inflation expectations. The first reason is that even though Gold is seen as an inflation hedge, its strongest driver is real yields or real interest rates, which as you know is nominal bond yields minus inflation expectations.
So, let’s get US10Y on the screen for a second. You can see that even though inflation expectations has been moving higher, so too has US10Y, and the recent steepening has been very impressive.
Remember that fixed income assets hate inflation, because inflation erodes the future value of money, so if inflation rises that is bad for bonds, and as investors rotate out of bonds that pushing bond yields higher. They can of course still hold treasuries, but they’ll rather opt for something inflation protected treasuries like TIPS.
So, the first reason why I think Gold isn’t going up despite rising inflation expectations is that US10Y has been moving higher at a very fast pace, and yes real yields are still very low and slightly drifting lower, but because there is that anticipation of steeper curves the market is expecting real yields to rise, even if it’s by a small amount, and that is negative for Gold.
The second reason, and this is where it gets a bit more speculative on my side, is that I think the current market environment where we are in is bad for Gold even if inflation expectations rise.
Thing about it this way, imagine you are a portfolio manager that has a 10% allocation to Gold. You might be holding Gold more for it’s safe haven qualities in case things turn sour which makes sense. But holding it as an inflation hedge in the current market environment doesn’t make sense for me from a return point of view.
If you really wanted to protect your portfolio against inflation, and you want to use Gold for that purpose, that would only make sense if your portfolio was 100% allocated to Gold, otherwise you are just protecting 10% of your portfolio against the expected inflation.
So, what makes more sense, if you are a portfolio manager, is to allocate other parts of your portfolio to assets which will outperform inflation, not assets that just wants to hedge against inflation. Thus, for me, in the current reflationary environment, if you really wanted to hedge against inflation, then wouldn’t you rather allocate to assets that are more correlated to inflation expectations and are expecting to perform really well with inflation?
For me that would make a lot of sense, and that’s really where commodities in general come into play. If we look at the CRB commodity index, we can see it’s a lot more correlated to inflation expectations compared to Gold.
Apart from that, if we just look at something like Oil alone, and look at the performance, it’s up 10% MTD, up 56% in the last 3 months, and up almost 20% YTD. Doesn’t that look like something that makes more sense to hold as an inflation hedge, because it’s expected to follow inflation higher and with bond yields expected to rise which places downside pressure on Gold it makes sense that this would be a much more preferred hedge against inflation.
But, like I said, that is very speculative on my side, I’m sure there are much smarter people than me that might disagree with me regarding this second part, but it makes sense for me from a portfolio allocation point of view.
So, hope that helps with the question, and others don’t hesitate to let us know.
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------------------------
We have a great question here from a subscriber asking about Gold, saying if the market thinks that we’ll get higher inflation and since Gold is seen as an inflation hedge, shouldn’t Gold be moving higher as inflation expectations push higher?
This is such a great question, and something that we’ve had other questions about in the terminal recently as well.
You’re right that Gold has traditionally been seen as an inflation hedge, because it’s a hard asset that keeps it’s value, so as currencies lose value as inflation rises, Gold should not, so it’s seen as a hedge for when inflation goes up.
However, I think there are two very important reasons why Gold is not moving up alongside inflation expectations. The first reason is that even though Gold is seen as an inflation hedge, its strongest driver is real yields or real interest rates, which as you know is nominal bond yields minus inflation expectations.
So, let’s get US10Y on the screen for a second. You can see that even though inflation expectations has been moving higher, so too has US10Y, and the recent steepening has been very impressive.
Remember that fixed income assets hate inflation, because inflation erodes the future value of money, so if inflation rises that is bad for bonds, and as investors rotate out of bonds that pushing bond yields higher. They can of course still hold treasuries, but they’ll rather opt for something inflation protected treasuries like TIPS.
So, the first reason why I think Gold isn’t going up despite rising inflation expectations is that US10Y has been moving higher at a very fast pace, and yes real yields are still very low and slightly drifting lower, but because there is that anticipation of steeper curves the market is expecting real yields to rise, even if it’s by a small amount, and that is negative for Gold.
The second reason, and this is where it gets a bit more speculative on my side, is that I think the current market environment where we are in is bad for Gold even if inflation expectations rise.
Thing about it this way, imagine you are a portfolio manager that has a 10% allocation to Gold. You might be holding Gold more for it’s safe haven qualities in case things turn sour which makes sense. But holding it as an inflation hedge in the current market environment doesn’t make sense for me from a return point of view.
If you really wanted to protect your portfolio against inflation, and you want to use Gold for that purpose, that would only make sense if your portfolio was 100% allocated to Gold, otherwise you are just protecting 10% of your portfolio against the expected inflation.
So, what makes more sense, if you are a portfolio manager, is to allocate other parts of your portfolio to assets which will outperform inflation, not assets that just wants to hedge against inflation. Thus, for me, in the current reflationary environment, if you really wanted to hedge against inflation, then wouldn’t you rather allocate to assets that are more correlated to inflation expectations and are expecting to perform really well with inflation?
For me that would make a lot of sense, and that’s really where commodities in general come into play. If we look at the CRB commodity index, we can see it’s a lot more correlated to inflation expectations compared to Gold.
Apart from that, if we just look at something like Oil alone, and look at the performance, it’s up 10% MTD, up 56% in the last 3 months, and up almost 20% YTD. Doesn’t that look like something that makes more sense to hold as an inflation hedge, because it’s expected to follow inflation higher and with bond yields expected to rise which places downside pressure on Gold it makes sense that this would be a much more preferred hedge against inflation.
But, like I said, that is very speculative on my side, I’m sure there are much smarter people than me that might disagree with me regarding this second part, but it makes sense for me from a portfolio allocation point of view.
So, hope that helps with the question, and others don’t hesitate to let us know.
-----
If you find this content helpful, you’ll love Financial Source.
There’s a link below were you can learn more about it
https://financialsource.co
