In the past, gold has been bought as:
- an inflation hedge; or
- a safe haven.
In this Record, I use the slope of the UST yield curve (5/30 year) to gauge which of those two factors is the strongest.
If gold is an inflation-hedge then we should have the following relationship:
Higher (lower) gold prices => increase (decline) in inflation expectation => Bear steepening (bull flattening) of the curve
(A bear steepening is when the slope of the yield curve increase through higher long term interest rates).
I use the 5/30 year segment of the curve to gauge the inflation risk premium. Using shorter maturity for the calculation might be skewed because the very short end is pegged by the current Fed guidance (no rate increase until mid-2015).
If gold is a safe haven asset:
Higher (lower) gold prices => increase (decline) in risk aversion => Bull flattening (bear steepening) of the curve
(a bull flattening is when the slope of the yield curve declines through lower long term interest rates).
This is due to the fact that during periods of risk aversion investors would rush to purchase long-dated bonds.
The chart below shows that the current selloff of gold came along with a flattening of the curve. Even if the relationship has been weaker over the last few months, we can see that in the past, higher gold prices came along with a steeper yield curve.
This suggests that the inflation hedge factor is the strongest. This view is confirmed by the strong correlation between TIPS breakeven and gold prices (a fall in gold = a fall in breakeven).
This analysis confirms that gold is clearly not a safe haven, and is still behaving (at least in part) as an inflation hedge.
What does this mean for investors? Are they right to sell gold, as the President of the Federal Reserve Bank of St. Louis, James Bullard, thinks that "Inflation is running very low" and states that he is "getting concerned about that"?
Well, the link between genuine inflation and gold has been week over the past decades. This is something very well documented. In addition, gold prices should, above all, be linked to real interest rates, not only to inflation.
But, as we have seen in the chart below, gold is far from useless as a hedge: it helps hedging the negative outcome that changes in inflation expectations may have on some asset returns, sovereign bonds in particular.
Assets whose returns are affected by (founded or unfounded) inflation expectations can still be properly hedged with gold.