Investors in gold and investors in bonds cannot both be right

Record high for the metal suggests that debt markets have got it wrong on inflation

Tommy Stubbington

Analysts at Goldman Sachs have increased their 12-month price target for gold by $300, to $2,300 a troy ounce © REUTERS

Gold is shiny but ultimately useless. At least that is what sceptics of the metal’s virtues as an investment are fond of pointing out, highlighting the lack of any income from holding it.

But in the topsy-turvy world of financial markets in 2020, an income of zero can sometimes look attractive. Not only does nearly $15tn of debt around the world trade at a sub-zero yield, but the US Treasury market — one of the last bastions of positive income among highly rated government bonds — is now dogged by negative real yields, once inflation is taken into account.

The vanishing returns on offer from debt markets are one reason why the price of gold broke through its 2011 record high this week. So too is the dwindling appeal of bonds as a haven, which undermines the traditional “60/40” idea of investment.

According to that theory, the 40 per cent of a portfolio invested in bonds will rally when equities drop, cushioning losses in the remainder allocated to stocks. But with yields at record lows around the world and central banks damping down volatility with policies that veer close to formal yield targets, that logic seems shakier. Bonds appear to have little room left to rise in the event of a stock market sell-off.

It is little surprise, then, that investors are casting around for new ways to offset their exposure to stocks. For many, gold stands out.

“We’ve had a lot of questions from clients who are interested in gold as a hedge for equities,” said Dario Perkins, managing director for global macro research at TS Lombard. Mr Perkins said these inquiries began during last year’s surge in negative-yielding debt around the world, but have intensified in the wake of the coronavirus crisis as the scale of the Federal Reserve’s bond-buying forces real yields to new lows.

Many investors are aware that the negative correlation between bonds and equities is not an iron law of finance, but a relatively recent phenomenon. Prior to 2000, fixed-income markets tended to rise and fall in tandem with stocks.

Still, for those making the switch to gold as their preferred hedge there is bad news: bullion’s record as a negatively correlated asset is even patchier than bonds’. Mr Perkins, who has run the numbers going back a century and a half, said gold has occasionally offered a useful alternative, but more often has been positively correlated with stocks at times when bonds have too.

Only during bouts of severe inflation — most recently during the 1970s — has gold provided a counterweight to equities, while fixed income did not. More normal is the kind of relationship seen in March this year, when a brief but sharp sell-off in gold came at the height of the carnage in stock markets.

A return of inflation after decades of sluggish price rises, however, is exactly what many gold buyers are positioning for. Governments around the world are issuing record amounts of debt while central banks have been buying bonds at breakneck speed, partly in an attempt to curb borrowing costs. If the global economy were to shake off the effects of Covid-19 quickly, prompting growth and inflation to return, central bankers are unlikely to be in a hurry to withdraw that stimulus.

Analysts at Goldman Sachs cited a potential shift by the Fed “towards an inflationary bias” last week when they increased their 12-month price target for gold by $300, to $2,300 a troy ounce.

Bank of America pointed to another link between bond markets, gold, and the threat of inflation. Michael Hartnett, chief investment strategist, wrote recently that central banks’ bond-buying is thwarting investors who might otherwise bet on higher inflation by selling or shorting government debt. Instead, such would-be bond vigilantes are being “crowded in” to the gold trade.

It is worth remembering that investors have come unstuck betting on inflation in the past. After the last financial crisis, many assumed the unprecedented levels of monetary stimulus would unleash a wave of price rises. Instead, a decade of very low inflation followed.

Many bond investors appear to have learnt that lesson. Although the recent declines in real yields are a result of rising inflation expectations being priced into bond markets, the levels remain low by historical standards. The US 10-year break-even rate — a gauge of expectations of price movements that measures the gap between yields on regular and inflation-protected bonds — is currently at 1.5 per cent. Markets expect an even lower rate in Europe.

Partly this reflects the distorting effects of quantitative easing — by pushing down nominal yields central bank purchases tend to squeeze break-evens. But many investors also harbour doubts over the case for higher inflation, not least because the demand shock of coronavirus has many major economies staring at the possibility of outright falls in prices.

For gold to prove its worth — either as a portfolio stabiliser or a longer-term inflation hedge — bond markets will have to be proved very wrong.

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