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One of, if not the earliest articles I wrote for Seeking Alpha was about how Gold or SPDR Gold Trust (NYSEARCA:GLD) was behaving like a leveraged bond fund. The reason I wrote it was to highlight that the inflation theory of gold didn't make any sense in this economic environment. Bonds are the anti-inflation hedge, and leveraged bond funds were anti-inflation hedges on steroids. It makes absolutely no sense for GLD and leveraged bond funds to be correlated if in fact the markets were discounting inflation. My thesis was that because of the zero interest rates, GLD was simply a substitute for bonds. GLD doesn't pay a dividend, but neither were bonds, and GLD provided a safe haven and hedge against inflation. GLD was a hedge against fear, not inflation.

Well, that theory has proven itself valid on a monumental scale. As the economy has recovered and bonds have started paying a higher yield, gold prices have crumbled. Not only have they crumbled, they have crumbled much faster than the leveraged bond fund I used in the original analysis.

In the original article, GLD and the leveraged bond fund Pro-Funds Ultra 7-10 Year Treasury (NYSEARCA:UST) were highly correlated and were about 13% difference in performance from early 2010.

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Since that time period the correlation has broken down, with GLD falling much more rapidly than UST. The difference between GLD and UST is now over 35%, and widening.

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In conclusion, the price action of GLD pretty much proves that the markets aren't perceiving inflation as a threat, at least not now. If they were, GLD would rally on the news of strong jobs growth, not sell off. This historical relationship between GLD and inflation however has led many people to invest in gold for all the wrong reasons. Yes, gold is an inflation hedge, but it is also a substitute for other non-productive assets. When rates are near 0%, bonds are basically non-performing assets, and their duration risk reduces their safe haven appeal. GLD has been bid up because of the substitution effect and safe haven buying, not because of any realistic fear of inflation... no matter how many times that myth is repeated. If investors want to know where GLD is headed, all they need to do is watch the interest rates. As interest rates increase, GLD will sell off, as will the leveraged bond funds. That relationship will continue to hold until the markets actually believe inflation is a realistic threat, and when that happens, GLD will no longer be a safe haven substitute for bonds, it will return to its classic role as an inflation hedge. That however is a long way in the future, and I would expect GLD to go lower, much lower (below $1,000), before it is needed as an inflation hedge.

Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

Source: Gold Continues To Behave Like A Leveraged Long Bond, Not An Inflation Hedge