Talkin’ ‘Bout the China Gold (Whoa Oh)
I ran this chart in the Quarterly Inflation Outlook released 3 weeks ago or so.
Here’s what I wrote:
In general, gold behaves like a very-long-duration inflation-linked bond with a zero coupon. This makes sense – if we were to issue a bond that, in exchange for the current gold price, offered to pay the bearer no coupons but redeem for 1 ounce of gold in 100 years, it would have the same payoff as holding one ounce of physical gold for 100 years. If gold is a true inflation hedge over time, which means its price rises with the price level, then that bond would have the same payoff if we defined the payoff not in terms of an ounce of gold, but in terms of the change in the price level over that 100 years. And that would be a 100-year zero-coupon TIPS bond.
So, we tend to see over time that the spot gold price tends to track pretty well to the implied price of a zero-coupon TIPS bond. The chart above (Source: Bloomberg and Enduring calculations) illustrates the stark divergence which started roughly when the Fed began its tightening campaign. We do not have a very good explanation for this divergence, other than to postulate a clientele effect in that perhaps gold investors are more animated by inflation and TIPS investors tend to be less-excitable institutional owners. Whatever the cause, at the moment gold represents a TIPS bond that is yielding about -2.25% real yield, or roughly 435bps expensive. Unfortunately, relative value observations like this have no mechanism to force them to close, so we cannot recommend selling gold and buying TIPS as an arbitrage. However, we are comfortable saying that investors could create a significantly better-performing commodity index by leaving gold out of the index, or by replacing gold in the index with a TIPS bond. Call Enduring Investments if you are interested in creating such an investment!
At the time, I wasn’t aware (because I don’t track gold flows – gold to me is just another commodity, albeit one that has a very high real duration and a pretty low inflation duration) that China has been buying gold consistently for a year and a half. That only became apparent to me recently when news stories highlighted that China has stopped the accumulation for now. Here is a chart from Bloomberg of China’s monthly gold reserves. It certainly seems as if the timing of the Chinese purchases correspond reasonably well with the divergence in the first chart above.
However, I am not sure that’s the true reason although it is probably a contributor. If you back up and look at China’s reported reserves over the entire period covered by the first chart above, you can see that the recent increase is the largest since 2015…but certainly not the largest on record. Even if the jumps on the chart are due to less-regular reporting updates, the overall rate of increase prior to 2016 was not dissimilar to that of the last 18 months. And yet, that buying did not cause a divergence of any meaningful amount on the first chart above.
So I am back to thinking that this is a broader clientele effect, of people who responded to the biggest spike in inflation in 40 years by buying an asset that historically has sort of a meh history of protecting against inflation over short or medium periods, and a much clearer history of large yield sensitivity. If that’s the case, then while there’s no trigger for closing the gap we should expect that the gap will, eventually, close. Which preserves the implication I mentioned in the Quarterly Inflation Outlook: prudent investors should consider lightening the allocation to gold in their commodity allocations.
As an aside, the title of this piece comes from a song by the Doobie Brothers that I can’t get out of my head now, and hopefully neither will you!
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Here’s a fun exercise for you that I have done. Instead of looking at what real yields imply the fair value for gold is, why not look at what the price of gold is telling us the fair value of real yields? In other words, Gold is telling us the breakeven inflation rate is 100-200 bps too low
To be clear, gold doesn’t really directly tell you anything about breakevens. Your assessment of the future price of gold should not change the fair value of today’s price. It’s real yields that tie the two together. So indirectly you’re right, but way too low. The price of gold implies that real yields are more than 400bps too high, and therefore breakevens are more than 400bps too low.
The truth is probably in between. Breakevens are far too low, and gold is far too high.
I have never liked gold or any of the precious metals as an investment, nor as a unit of value. While I acknowledge that there is a finite amount of them, the main restriction limiting an over abundance is a matter of collection and purification. I admit that I do not have a suggestion for a better base unit of value. I am suggesting that the material representing the basic unit of value can be changed due to many factors, probably mostly due to cultural expectation — enter electronic currencies. I am not a fan of those either so let’s just stick with gold.
Personally I think a broad basket of non-perishable commodities (including precious metals but also industrial metals, energy, etc) would be better than gold by itself, but many of those other commodities also have inflation expectations delta. But none of these is very good in the short-run. In the long run, a basket makes more sense to me. Digital currencies have no sensible relationship to the price level.
Is it possible to extend the gold-TIPS chart back to 1973 (perhaps using some measure of cumulated inflation expectations rather than TIPS prior to 97)?
IIRC Gold has rallied to a new peak at least 2x or 3x higher each time it’s made a new high. Would that have been possible without periodic resets in the gold/TIPS ratio? It looks like that’s been around 13, for ~16 of the last 18 years, based on ‘fitting’ to 06-24 data in the gold-TIPS chart… but this is surely arbitrary (since it’s based on an arbitrary unit: 1 TrOz of gold.)
Interesting post I saw on twitter indicating that the gold rally started after Russian invaded Ukraine and as a result had it’s reseves seized. This was around the same timing as when the Fed started to hike.
https://x.com/ironmaker001/status/1778752592635445277
China is obviously not the only sovereign actor getting rid of them dollar reserves. Hence, gold increasingly assumes the role of a universal hedge as the ‘rule based’ world order is about to experience its final throes
China Grove is a classic! Tracy Chapman comes to mind when “talkin’ bout” something too.
I think there’s more at play here than China or gold bugs inspired by the first whiff of government-induced inflation in several decades. The story might be more about a loss of confidence in holding Western (and particularly US) debt after the dubious confiscation of Russian assets held by Western governments after the start of the Ukraine war. Personally, I’m with the Ukraine… but. From the standpoint of centuries of international law and norms, the confiscation of Russia’s assets was a travesty that will lead to an unraveling of confidence in the West by many global market participants, particularly those we in the West deem undemocratic or otherwise not in line with the values we espouse.
Let’s not forget that despite all the evils of Nazi Germany, we never confiscated their assets held by international lenders and governments.
The US treasury market relies upon trillions of dollars of purchases from foreign countries. Not all of them are good citizens. When those countries perceive that we, or other Western governments, might simply decide to seize their assets when they do something we disagree with – however right or moral our disagreement with their actions may be – then naturally those countries might decide the risk to holding those assets is not insignificant.
Why would China recycle their trade surpluses into US treasuries if one day we might say, well, you invaded Taiwan, we’re taking your money? Ditto African nations, or South American countries, and many of the emerging world.
What are their alternatives? Well, gold might seem like a good one. Set aside the fact that it has little use as a commodity, pays no interest and is therefore a relatively unproductive asset. It has a long history as a store of value, and is therefore a potentially “safer” alternative than an asset which was once presumed to be risk-free, but now carries the risk of being confiscated if the buyer of it is frowned upon by the issuer.
Excellent point. Another commenter also pointed out the timing of the seizing of Russian reserves. Thanks Michael!