Gold vs. Treasuries: Something's Gotta Give

Includes: GLD, TBT, TLH, TLT
by: David Roda, CFA

It just doesn’t add up. Gold is hitting all-time highs, credit spreads are contracting, the stock indices are in rally mode, and yet the yield on the ten year Treasury bond has fallen to 2.50 percent – not far from the lows seen during the throes of the global banking crisis. The natural order has been deliberately altered by the politicians and monetary authorities in an attempt tame the economic cycle. Sooner or later the irrepressible nature of the market forces will prevail, and the animal spirits will again be driven by fundamentals factors like economic activity, inflation, and valuation. At that point, Treasury yields will rise or gold prices will fall –or maybe both. Either way, something has to give.

Gold has rapidly ascended to levels that cannot be fully explained by the forces of inflation and organic supply-demand growth. This sort of price leap has historically occurred only during periods of hoarding, which are typically associated with hyper-inflationary expectations or a general loss of confidence in paper money, or both. Since inflation is obviously not a concern at the moment, the pundits are attributing rising gold prices to the erosion of investor confidence in the inherent safety of government debt and paper money. This argument has some merit given the widespread level of uncertainty regarding the global economy, the murky regulatory climate and mounting fiscal deficits. Nonetheless, I think there is more to it. The advent of highly liquid gold ETFs has provided investors of every size with easy access to the yellow brick - and boy did they buy. By our calculations ETFs now control as much as 6% of official world gold reserves, ranking sixth in size behind France and just ahead of China.

On top of that, central bank reserve building is also contributing to the surge in gold demand, especially among countries like China and India that maintain large U.S. dollar trade surpluses. Their coffers are chock full of Treasury bonds and they are undoubtedly keen to diversify or to hedge dollar risk. However, they realize that a large scale conversion of dollars to other currencies would adversely affect exchange rates and result in trading losses. In light of this, the dollar surplus countries seem to be systematically buying gold, oil and other real assets that tend to offer some protection against a falling dollar and rising U.S. interest rates.

I accept the argument that gold prices have ratcheted higher as a result of expanding ETF and central bank demand. However, I am convinced that a significant portion of overall gold demand is speculative in nature. Traders are swarming all over the metal like bees to honey. At the first sign of economic stabilization, they will quickly buzz away, stinging unwary retail investors whose chubby hands are stuck in the pot. Treasury bonds are another story altogether. Let’s just assume for a minute that rising gold prices properly forewarn of a systemic loss of confidence in the quality of the dollar or a basket of major currencies. If the dollar weakens, Treasury yields will have to rise in order to compensate foreign holders for the currency losses they incur. The developed countries in Europe have all enacted fiscal austerity measures aimed at deficit reduction.

The U.S. has no austerity plan in place. U.S. deficits are projected to continue to expand at a faster pace than the rest of the world. At what point do foreign buyers become saturated? The US has issued almost half of all government debt floated in so far 2010, yet the US only accounts for about one quarter of global GDP. Likewise, if other governments follow our example and lean too heavily on the money printing presses, then investors will get squirrely and will demand higher yields across the board to compensate for the global erosion in credit quality. Of course there is a chance that an abrupt and violent loss of investor confidence could send everyone running for the hills again. In this case gold could rise further, the dollar could strengthen, and interest rates could decline from current levels as the herd stampedes toward the relative safety of U.S. Treasury bonds. If this were to happen, equity markets would crash, credit spreads would quickly widen, and we would be right back where we were in 2008 – only worse.

Is another global financial meltdown likely? No, but it is possible, and on the surface the dislocation between Treasury yields and gold prices today seems to be pointing in that direction. But if we look deeper we can see that the Federal Reserve Bank is desperately trying to keep Treasury bond yields low in order to prevent the fragile economic recovery from derailing. The Fed is now resorting to non-core strategies such as buying long-term Treasury bonds with the proceeds from several hundred billion dollars of maturing mortgage -backed securities they picked up during the bank bailout. There is now talk of further quantitative easing (QE2) on the order of $1.5 trillion or more. If enacted, QE2 could push rates even lower for awhile and result in modest economic stimulus, but lower yields might negatively influence investor demand, thus limiting its effectiveness.

However, there are various players helping to soak up the wave of Treasury issuances. Banks are flush with cash and in the absence of quality lending opportunities, they have been re-investing their cash hoards in slightly longer-dated government bonds and earning nice, low-risk spreads. The Japanese are aggressively trying to push down the value of the Yen versus the US dollar, in part by buying tons of Treasury paper. The Chinese are still big buyers of U.S. government bonds, but have begun to shorten maturities and make noises about their mounting risk to the dollar. It is a tenuous relationship. If the Fed is successful in its stimulus efforts then the entire yield curve will eventually adjust higher. If not, rates might rise anyway as investors become less willing to increase exposure to U.S. government debt at today’s artificially low yields.

The bottom line on gold is that legitimate sources of investment demand have justified part of the upward trend in prices, but the speculative element seems to be increasing and caution is advised. Everyone likes gold. The pundits are uniformly predicting huge moves to the upside. The airwaves are being polluted with television and radio ads urging retail investors to “BUY GOLD NOW”. Gold may go up more, but to me it is starting to smell like a bubble in-the-making.

As for long term Treasury bonds – What can I say? Buy and hold investors should run for the hills. The Treasury market has become a trader’s game. Even in a benign economic environment, return prospects are limited and price risk is high. Having said that, yields will likely remain depressed for some time during this period of active intervention, and they could even go lower if the Fed pulls the trigger on further quantitative easing. Nonetheless I worry a lot about the erosion of the U.S. balance sheet and its ultimate impact on the yield curve, especially when I consider the estimated $99 trillion net present value of unfunded Medicare and Social Security liabilities that are not reflected in the official numbers.

Disclosure: Steering clear of Gold and Treasuries