Gold went from about $250/oz to almost $2,000/oz during a time period when inflation as measured by the Consumer Price Index or CPI has been flat actually falling. This chart shows the annual % change in the CPI.
This chart shows the CPI (Red Line) vs. Gold (Blue Line) indexed to 100 at the chart's mid-point. Gold has outperformed the CPI on a ginormous scale. Over the last 10 years gold has gone from and index value of about 45 to a peak of around 240, and back to around 180. The CPI had a rather consistent march from an index value of about 85 to 110.
On a historical basis, the trend in the CPI has remained essentially unchanged from the early 1980s, and if anything, its slope has been decreasing.
If gold is an inflation hedge, investors need to ask themselves why gold has done so well in spite of the lack of inflation? Clearly there must be something wrong with the model.
Gold bugs will argue that printing money is inflation, and therefore gold is simply reflecting the true definition of inflation. They will say the bond markets simply don't understand inflation, and that printing money, not changes in prices are what matters, and besides, you can't trust those government CPI numbers anyway, they are rigged. The problem with this theory is once again, it isn't supported by the facts. This chart shows M2 Money Supply or M1 and gold over the last 10 years indexed to 100 and the midpoint. M1 was basically unchanged over the first 5 years, and yet gold went from about an index value of 45 to a peak of about 130. M1 then went from 100 on the index to about 180, and gold went from about 100 to a peak of 240 on the index. The problem is M1 took a sharp increase post-2011 increasing from 140 to over 180 on the index, yet gold dropped from about 240 to under 160 on the index during that time period, and appears to be in the midst of a bear market.
If printing money causes gold to go higher, the first 5 years, and the last 2 years, 7 out of the last 10 years, don't make a very solid case for that theory. Not surprisingly, the Austrian School of Economics is known for eschewing the application of scientific data analysis to economics.
Clearly from the above data sets, there is a real problem with the conventional wisdom on gold/SPDR Gold Trust (GLD), and is close cousin silver/iShares Silver Trust (SLV). The reason gold's behavior only fits the theory 3 out of 10 years is because gold is defined by an asymmetric multi-variable model. During the pre-2008 crisis period gold did well as central bank selling subsided and economic strength in the US resulted in increased expectations of inflation in spite of the lack of monetary stimulus. At one time in 2007 unemployment got down as low as 4.4%, well within the range that economists fear would trigger inflation. Inflation fears/expectations coupled with lack of central bank selling drove gold higher between 2003 and 2008, not the printing of money.
Gold's initial reaction to the 2008 crisis was to sell off, even though the M1 was increased. Gold fell from an index level of about 130 to 90 with the onset of the 2008 crisis, and only got back up to the pre-crisis peak on the index of 130 after the money supply had been increased a full 20%. It is worth noting that gold didn't breach its pre-2008 crisis peak until late 2009 early 2010, well after QE had started.
Gold then correlated well with M1 for all of 2010 through its peak in mid-2011. During that time M1 increased from about 120 to 160 on the index, and gold went from about 120 to 240 on the index. That brief time period of correlation however was followed by a complete reversal. From mid-2011 through late August 2013 the index value of gold fell from 240 to about 150, and now rests near 160. During that same time period the index value of M1 went from about 140 to 190. The recent low of 150 set on the gold index is consistent with the late 2009 early 2010 peak of M1 set when M1 was at an index value of 120. The M1 increasing from 120 to 190, an over 50% increase, had effectively no impact on the price of gold. There are plenty of people that bought gold in 2010 that are taking a loss, and basically all people that bought gold in 2011, 2012 and most of 2013.
Clearly the single variable model of printing money drives gold higher simply doesn't withstand even the most elementary level of analysis, so there must be other factors that move gold. Expectations of low unemployment causing inflation and a dearth of central bank selling drove gold from the early 2000s up to the 2008 crisis. The immediate impact of the 2008 crisis was to send gold lower, even with an increase in M1. Expectations of a financial and banking system and currency collapse combined with fears of a QE driven inflation drove gold higher between early 2009 and mid-2011 as gold filled the role of both inflation hedge and safe haven.
Economic and financial Armageddon never happened and inflation never materialized, so the 2009 through mid-2011 gold rally largely corrected itself, and gold fell back mid-2009 levels. During the much that period gold acted like a leveraged bond fund. That correlation makes absolutely no sense what so ever if gold is an inflation hedge. What happened during that time was that gold was simply acting as a safe haven substitute for bonds. Bonds weren't paying any interest, so the choice between gold or a bond became the flip of a coin. This chart shows the relatively tight correlation between GLD and Pro-Shares Ultra 7-10 Treasury ETF (UST). If gold was only an inflation hedge, this correlation would never exist, there would always be a permanent negative correlation.
War drums are now providing some support for gold as investors rush to a safe haven, but for the most part the safe haven and inflation fear trade is dead. The possible bombing of Syria over the opposition of Russia and China has only resulted in a $24/oz bounce in gold as I write this article.
If my theory is correct that gold is defined by a complex multi-variable asymmetric model, not a simplistic symmetric single variable model of "print money gold go higher," then the above chart highlights why gold investors should be concerned. If, in the current market environment, gold isn't performing as an inflation hedge, and instead acting like a long bond substitute, gold will likely suffer as interest rates increase. That is in fact what has happened. This chart shows how gold has fallen as the 30 year Treasury rate increased. As rates go higher on expectation of economic recovery, the higher yields should attract money from the non-yielding gold.
Given the above charts, it is safe to assume that gold has already discounted a large amount of inflation that has yet to materialize. Looking forward, it is hard to make a case for inflation anytime soon, and certainly not before the ending of the taper and QE. With gridlock in Washington unlikely to change for at least another 3 years, and little chance of real headway being made towards a successful comprehensive stimulative fiscal program, I would expect the taper to last longer than the markets expects, inflation to be slower to materialize than the markets expect, unemployment to remain higher than the markets expect and growth to remain slower than the markets expect. The result will be that rates will increase slower than the markets expect, expectations of the taper will be reduced and pushed further back in time and this will result in a series of bear market rallies for gold.
Case in point is what is happening right now. The markets discounted a sizable taper to start in September, 2013. Those expectations were germinated when mortgage rates were a full 1% below where they are today and housing, unemployment, inflation and growth numbers were steadily improving. Things were looking good, but then interest rates had a sharp increase. Expectations of the taper drove rates higher, which in turn slowed the economy so that current economic numbers aren't so positive. The markets are now in the process of adjusting expectations for the taper amount, timing and level of interest rates lower. It is the classic tail wags the dog scenario, as well as a catch-22 for the Fed.
If my theory is correct, inflation is the last thing investors should be worried about, and that doesn't bode well for gold. Going forward recovery should be slow and sporadic, unemployment should slowly fall and interest rates should have a slow march higher. As mentioned above unemployment got as low as 4.4% failed to generate inflation of any concern. The economy has to first stabilize, recover and even accelerate before it will be able to reduce unemployment to a level that would raise inflation fears. That is a long way off. Before we get to the point where inflation can actually support gold, or even drive it higher, the rate of inflation must exceed the level of inflation already discounted in the price of gold, and considering that gold has gone from around $250/oz to $1,400/oz without any actual inflation, there is a substantial level of inflation already discounted in its price.
The alternative inflation hedge, inverse bonds funds, have basically no inflation already discounted in them. Bond rates are coming off historic lows, and are headed higher without inflation as the taper gets implemented. While gold should be dead money during the taper, inverse bond funds should do well. Inverse bonds funds should do well in the short run as the taper begins, during the intermediate term when the taper gets implemented, during the long run when the recovering economy drives rates higher and generates inflation and during the very long term when inflation finally gets to a level that would actually exceed that already built into the price of gold. If inflation is being used as a justification to support an investment, inverse and leveraged inverse bond funds are far superior to gold.
- ProShares Short 20 Year Treasury (TBF)
- iPath US Treasury 10-year Bear ETN (DTYS)
- ProShares Short High Yield (SJB)
- ProShares Short 7-10 Year Treasury (TBX)
- iPath US Treasury Long Bond Bear ETN (DLBS)
- iPath US Treasury 2-year Bear ETN (DTUS)
- Direxion Daily Total Bond Market Bear 1x Shares (SAGG)
- Direxion Daily 20-Year Treasury Bear 1x Shares (TYBS)
- ProShares Short Investment Grade Corporate (IGS)
- iPath US Treasury 5-year Bear Exchange Traded Note (DFVS)
- Direxion Daily 7-10 Year Treasury Bear 1x Shares (TYNS)
- ProShares UltraShort 20 Year Treasury (TBT)
- Direxion Daily 30-Year Treasury Bear 3X (TMV)
- ProShares UltraShort 7-10 Year Treasury (PST)
- ProShares UltraPro Short 20 Year Treasury (TTT)
- Direxion Daily 10-Year Treasury Bear 3X (TYO)
- PowerShares DB 3x Short 25 Year Treasury Bond ETN (SBND)
- JP Morgan Double Short US 10 Year Treasury Futures ETNs (DSXJ)
- JP Morgan Double Short US Long Bond Treasury ETNs (DSTJ)
- ProShares UltraShort 3-7 Year Treasury (TBZ)
From mid to late April 2013 when interest rates bottomed and building expectations of the taper drove the 10 year treasury rate up over 1% in under 4 months, TBT is up almost 26%, while GLD is down 5%. That is the benefit of an inverse bond fund over gold. It is a mathematical certainty that bond prices will fall as interest rates increase, that mathematical certainty does not apply to gold. Inverse bond funds are far more likely to generate positive returns as rates increase than gold is. In the early stages of the taper and as it is implemented, rates should go higher without inflation, so gold should fall as inverse bond funds head higher.
Another interesting spin on the above theory would be a market neutral position of long an inverse bond ETF and short GLD. That would moderate the inflation risk of the portfolio, and allow the investor to benefit from the rise in interest rates as the taper is implemented. This chart demonstrates how a 50/50 long TBF/short GLD would have returned about 8.7% from mid April.
Caution: I mentioned and included leveraged inverse bond funds in the above list and discussion. The leveraged aspect adds an additional level of risk and complexity and alters the mathematical relationship between interest rates and the bond price. Be sure to thoroughly understand the risks involved before ever considering a leveraged instrument. A 50% loss requires a 100% gain to get back to even, and quite often the index on which a leveraged ETF is based can be up, when the leveraged ETF can be down by a sizable margin.
In conclusion, the path the economy is likely to follow going forward will be a slow, sporadic crawl towards recovery. Inflation is likely a long way off, and with almost 100% certainty, interest rates will go higher before inflation develops. That is in fact what is happening right now. Inflation is usually the last thing to develop in an economic recovery, and because of that gold is likely to be dead money, and will likely head lower before it goes higher as people sell the non-yielding gold to buy the higher yielding bonds. In investors are holding gold as an inflation hedge, they would be far better off selling their gold and buying an inverse bond fund. Inverse bond funds would be expected to do well when interest rates head higher without inflation, as well as when interest rates head higher because of inflation. Inverse bond funds should do well under both scenarios, whereas gold should do well under only one.
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.