Gold is trading at a record high today—roughly $1240/oz as we write this morning. The standard interpretation is that the metal is pricing in higher inflation in the years ahead. That’s an accurate reading of gold’s message, but the analysis is more complicated than usual once you consider the metal’s trend of late in context with other markets and the global economic climate. In the short term, the rising demand for gold is also telling us that the risk is rising (again) for a new wave of deflation in the months ahead.
One sign that the higher gold price is less about inflation in the near term is the concurrent increase in the dollar. That's unusual. Over the last several decades (the modern age of fiat currencies), the greenback and gold have generally shared a negative correlation. When one rises, the other falls. Not every day, week or even month, but in the grand cycle of global economics the dollar and gold are competitors as a monetary store of value. (Click to enlarge)
For good or ill, the dollar is the world’s reserve currency in practice. That's a role once held by gold. But while the metal is no longer official legal tender, old habits die hard. As such, gold is still widely considered money, and to an extent it represents, an alternative to the dollar, at least on the margins.
Meanwhile, the greenback's fluctuations aren't always a straight reflection of the economic outlook of the U.S. Given its role as the world's reserve currency, the dollar’s rise is also a sign of rising risk aversion around the world. In that case, the dollar’s value may climb against foreign currencies even when gold’s price is ascending. That certainly sums up the current climate.
For the year so far, the dollar is higher by about 9%, based on the U.S. Dollar Index. Meanwhile, gold is up about 13% year to date. Simultaneous, ongoing rallies in both is fairly rare. What does it mean? Call it the flight-to-safety trade, which is benefiting gold and the dollar.
Investors around the world shifted assets back into the dollar, not because the U.S. is in a substantially stronger fiscal position than Europe or Japan. Although you can make the case on the margin that the U.S. economic situation is brighter, there’s no getting around the fact that America’s fiscal position in absolute terms is deteriorating--in sync with the rest of the developed world. In short, rising deficits and liabilities without (so far) the political will to raise taxes or cut spending in a meaningful way. The pressure valve, as a result, is higher inflation by way of printing money to solve the country’s fiscal troubles.
That scenario is obviously a plus for gold’s price. Presumably no one needs a primer on why gold is an inflation hedge. In a world that’s continually bailing out struggling companies and countries, and at the same time keeping keeping interest rates at rock bottom nominal rates, the potential for higher inflation is obvious. Indeed, the reason that so much of the developed world is engaged in providing emergency loans and the like is that demand for money exceeds supply sans government intervention. But the government is intervening. Where are the governments getting the money? They’re not raising taxes. They're not cutting services. That leaves the third choice: printing money. The mix may change in the future, but in the present that's more or less the reality.
Meantime, the risk of higher inflation isn’t imminent. In fact, we may not see prices rise in a material and sustained way for several years. Indeed, the market’s outlook for inflation has recently turned lower, based on the spread between nominal and inflation-indexed 10-year Treasuries. This market-based inflation forecast, while hardly the last word on the topic, does at least give us a sense of how the crowd is pricing future inflation risk. For the moment, that risk has fallen, as our chart below shows.
Lower inflation expectations are a good thing generally, although at the moment that’s a debatable point. As the chart above shows, the reflation efforts of central bankers has succeeded in printing away the deflation risk, which was a clear and present danger in late-2008 and early 2009. Higher inflation generally was required to keep the global economic system from imploding. It worked. The question is whether the deflationary winds are again blowing?
It’s too soon to say, although this risk bears watching once more. We already have some warning signs that alert us that risk aversion is rising--simultaneous increases in the price of gold and the dollar’s value. A falling inflation forecast in the Treasury market is another. If these trends continue, aided and abetted by falling equity prices and a new downturn in housing, we may be looking at another battle with the forces of deflation.
The critical factor will be the broad trend in economic growth. We can sum up this issue with one strategic question: How much of the fiscal and monetary efforts at ending the recession in the recent past has merely borrowed future growth? At some point, juicing the economy today diminishes the potential for growth tomorrow. You can’t get blood out of a stone, nor more growth out of an economy simply by printing money. At least not in the long run. In the short run, there’s a case for government intervention, at least in the darkest days of late-2008. But now we’re betwixt and between, juggling the risk of higher longer term inflation with the hazards of short term deflation (again), or so it seems.
The ultimate manifestation of deflation, of course, is a fall in the value of a nation’s GDP, a.k.a. recession. It’s premature to say that another recession looms. The economy, fortunately, has shown some ability to grow at a faster rate recently, as indicated by the accelerating pace of net job growth in the last two months. But this leads us back to the question of how much of the recent economic growth is simply borrowing future growth? No one really knows, of course, although it’s a safe assumption that some degree of borrowing is all but inevitable.
The risk of recession is still quite low, but the gold, forex and inflation markets are telling us that the risk is no longer falling and perhaps it’s even starting to rise.