Gold (NYSEARCA:GLD) has sparked investor interest, overturning a three-year bear market. Assisted by the recent safe-haven flows, which undoubtedly contributed to gold's bullish momentum, it has reached a price point that indicates extreme investor sentiment and positioning. This does not negate the fact, however, that an exogenous deflation shock to the economy could put the gold bull market in danger. This seemingly remote risk can be so impactful, if materialized, that gold investors should proactively execute some smart hedging tactics.
Real Interest Rates Drive Gold Demand
The current gold bull market can certainly be explained by the extreme positioning of real interest rates. Calculating the difference between 10-year swap rates and 10-year breakeven inflation rates indicates an abrupt drop of the 10-year expected real return on capital. This directly correlates with the latest acceleration of gold bidding, and proves once again the inverse relationship that exists between real rates and gold, a long-held dictum that dates back to the resolution of the Gibson Paradox. It is especially important to note that real interest rates have dropped below zero, creating an extremely prosperous ground for gold demand. The lower the real interest rates are expected to fall, the higher the demand for gold will be since hoarding cash presents a less lucrative opportunity than piling gold in such an environment. While it might be apparent why investment demand for gold is growing, it is perhaps not as easy to detect some hidden risks that may bring the gold bull market to its knees.
The Risk of Gold Reversal
If history repeats itself, then a possible gold reversal could occur, as was the case in 2012. At the time, gold might have been trading much higher, at the $1,600+ level, but it was doing so while real rates were crossing the below-zero threshold. The gold bubble burst in 2013 after real rates started to rise, bringing gold price down to approximately $1,050. This is very similar to the current gold market price, which is trading close to the $1,400 area, but it too is doing so in a negative real rate environment. In fact, one could argue that there isn't much of a difference between the current market price of gold and that of 2012 since the USD is much more expensive today than it was then. More specifically, the USD index is currently 19% higher than in it was in 2012, and the USD vs. yuan has appreciated almost by 6.5%. If these FX differences are used to translate the price of gold in foreign currency, then the current price for gold is equivalent to the $1,600+ level, making gold even more expensive today. Price points aside, the current gold bull market could be entering a similar trend reversal dynamic that will most certainly jeopardize gold investor holdings.
The Risk of Deflation
The only way for the gold bull market to sustain is if real interest rates keep falling, and financial repression succeeds. Policy makers try to deleverage their economies by engineering lower and lower real interest rates in hopes of devaluing the huge pile of sovereign debts. If this policy ultimately fails, or even worse, if a deflation shock occurs such as that of 2008, then the reign of gold will most certainly come to an end. When the financial crisis of 2008 broke, gold, interestingly enough, didn't function as a safe-haven asset, but instead lost almost a third of its value within seven months. This wild sell-off was directly driven by the plunge of the 10-year breakeven inflation rate from 2.5% to 0%. Investors reacted to fears of a new and prolonged deleveraging era of deflation.
There are many exogenous factors that can instigate a deflation shock, the most prominent one being a heightened capital flight from China. Such an instance would accelerate yuan's devaluation and effectively spread deflation to the global economy. The BOJ could also produce some deflationary reverberations to the rest of the world if it moves forward with its "Helicopter Money" policy and succeeds in reversing the yen uptake. Finally, an escalation of the European banking crisis could start a huge deflationary spiral and a fierce readjustment of inflation expectations. Therefore, the fear of an exogenous deflation shock should not be treated as a tail risk because it is more real than ever.
The Risk of Extreme Positioning
Be it the financial crisis of 2008, or the reversal of 2013, gold retracement came as a direct side-effect to the rapidly increasing real interest rates. Both instances mirrored the current investor sentiment, which reveals an extreme bias towards gold. According to CFTC's Commitments of Traders report, speculative net long positions have reached 300K on gold futures, reaching an eight-year high, while Bloomberg reports a climb in ETF global gold holdings to a three-year high. This indicates a tremendous exposure capable of producing heightened volatility if any of the above risks materialize. There is nothing to say that investors won't once again react erratically as they try to unload their excessive bets.
Gold Hedging Tactics
Although there is no perfect shield against such risks, a combination of a short position on a TIPS ETF, TIP, and a long position on a US Treasuries ETF, IEF, could act as a smart hedging tactic. For this strategy to be effective, both positions must be of an equal notional value and effective duration in each of their fixed income portfolios. This will isolate the interest rate risk and will produce capital gains if a deflation shock occurs. This tactic proved to be quite successful when it was applied in 2014-2016, during the last leg of the gold bear market, in which both positions generated capital gains. Even during the 2008 crisis where TIPS ETFs plunged but Treasury bond ETFs didn't exactly skyrocket, this hedging tactic still managed to generate combined capital gains.
Gold Investors Should Avoid Wishful Thinking
While it is clear that gold investors would much rather a scenario where real interest rates keep plummeting, financial repression succeeds, and no deflation shock occurs, the hidden risks are far too many for such wishful thinking. It is imperative that they act now and apply some smart hedging in order to arm themselves from the unknown. There are too many exogenous sources of deflation shocks to the US and global economy that the traditional safe-haven status of gold cannot battle them alone. Gold investors need reinforced weapons.
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