Forex Investment and Currency Trading

Gold prices have rallied 40% from late October lows. Traditionally, gold is thought of as a hedge against inflation. The spectacular rise in gold prices during the inflationary 1970s cemented conventional wisdom about the strong positive link between rising inflation and gold prices. Can this explain the substantial rise in gold prices over the past four months? Expected inflation (as measured by the spread between the yield on US 10 year Treasuries and 10-year TIPS) has risen by over 200bp since late November and over a 100bp since late October. So there is a case to believe that gold has been helped by rising inflation expectations and indeed record inflows into gold ETFs supports this view.

That said, if inflation was the key concern of investors, wouldn’t break-even inflation be even higher and breakeven inflation rates a better hedge? In this regard, it is also important to note that as gold prices approaches the highs seen last year, break-even inflation is still well over 100bp below the level that prevailed before the slump in inflation expectations during the second half of last year. More generally, if inflation was the main concern, then presumably rates markets would not still be pricing in further G10 monetary policy easing beyond the substantial rate cuts central banks have already delivered.

Has gold become a hedge against implicit deflation risks?

Because of this, some have argued that gold has instead become a hedge against deflation risk. In principle, this would fit in well with strong performance of gold during previous periods of deflation, especially during the 1930s. That said, interpreting this performance is complicated by the operation of the gold standard and by the subsequent decisions by many countries to devalue against gold.

Certainly, following the end of convertibility in the late 1960s and the introduction of flexible exchange rates, gold has not proved to be a deflation hedge. And it is hard to square the notion that buying a hard asset as a hedge against falling prices makes much sense.

So is gold vulnerable as we now enter a rapid period of global disinflation and rising deflationary risks? Perhaps not immediately for a number of reasons: Past periods of rising deflationary risks have been associated with households hoarding cash and cash-equivalents such as short-term U.S. Treasury debt, bank deposits, and moneymarket instruments. Gold and other precious metals are also seen as cash equivalents and perhaps a better store of value.

Related to the first point, gold could be preferable to currencies if there are concerns about the credit quality of the issuer of the paper currency. Indeed, the recent breakdown in the strong historical relationship between gold prices and the Euro/$ can be explained by the global nature of financial distress and the large-scale transfer of financial risk to governments, i.e. a stronger Dollar has recently been associated with a rise in gold prices. The increasing correlation between gold prices and measures of sovereign and financial risk default clearly suggests that gold has become the “currency of last resort”.

Consistent with the worries about sovereign default, it is clear that despite current deflation risks, there is a significant portion of investors who are concerned that currency debasement and significant inflation will be the endgame to the current pressure on balance sheets. If that fear is broad across the major currencies, that would strengthen the arguments in favour of gold.

Finally, the opportunity cost of holding gold is low in times of disinflation/deflation as central banks slash interest rates i.e. an investor in gold does not lose out significantly by holding non-interest-bearing gold during low rate environments.

As a result, gold appears to be benefitting from being the traditional hedge for inflation hawks and mistrust of cash assets and government obligations during the current financial crisis. And it probably only requires a minority of investors to believe that they need to continue to allocate more towards gold to have a significant price impact. Even with inflation risks low, those forces could continue to support gold prices.