Why Gold Fails as a Hedge Against Inflation (and when it works)

In the aftermath of Trump’s win, something that wasn’t supposed to happen, happened. Inflation expectations surged, but gold got clobbered:

The GLD fund, a proxy for gold, fell 8% (from $125 to $115) in the days immediately following Trump’s victory, and then it fell another $7 in December:

Inflation expectations, however, surged as shown by the spike in short-term yields in anticipation of considerable federal spending under the newly-elected Trump administration:

As shown above, interest rate expectations have ratcheted significantly, and the yield curve is expected to be much flatter due to short-term rates rising very quickly under Yellen’s rate hike regime.

And the week Trump won, treasury yields went nuts, in anticipation of higher interest rates and inflation:

Gold, which is touted as a ‘hedge against inflation’, failed spectacularly.

If you listen to talk radio or watch TV, there are ads that tout gold as a hedge against inflation. But gold also failed in 2013 when the fed announced the beginning the its taper program and the impending end of QE…But if the TV ads and Zero Hedge were right, the opposite should have happened: gold should have risen in anticipation of higher inflation due to the fed ending its QE program…So why in 2013 and 2016 did gold fall in anticipation of tighter monetary policy (taking away the punch bowl, as they say). Why is gold doing the very opposite to what everyone says or expects that it should? Why is gold not hedging this inflation?

There are a lot of subtleties to why gold behaves the way it does, and why it hedges but also fails to hedge. It took me years to understand this myself until only as recently as a month ago when I had an epiphany. People don’t really understand how gold or even how inflation works, even though they think they do.

Notice how I use the words ‘inflation’ and ‘interest rates’ almost interchangeably–but this is wrong–they are not interchangeable, although are often correlated. This key subtlety underlies why golds fails so badly for Americans who buy it as a hedge.

Let’s start with a simple example that shows when gold works as a hedge.

Let’s assume you’re a citizen of Venezuela, country that has 200% CPI inflation. But depositors in Bank of Venezuela only get 70% a year, because the central bank of Venezuela is always behind the curve on inflation. Inflation is rising faster than central bankers can keep up. Also, Venezuela has a really poor standard of living and a falling currency relative to the US dollar. $500 in Venezuela bank becomes $200 after a year, due to currency depreciation–even after taking into account the interest paid on deposits at Bank of Venezuela. This means your purchasing power relative to US dollars (or more specifically, American standards of living) shrinks considerably for anyone who has money in Venezuelan currency. This makes gold an effective hedge for preserving buying power (or more specifically, American US dollar wealth), because $1200 invested in an ounce of gold will still be wroth around $1200 after year (give or take 10% or so), versus only $400 after a year in equivalent Venezuelan currency.

But Americans aren’t citizens of Venezuela, yet they buy gold anyway. But what if America becomes Venezuela? Well, it can’t, because the US dollar is still the world’s benchmark of wealth and buying power, and until that changes (if it ever does), there is nothing to actually hedge. Also, US living standards, similar to the dollar, are a global benchmark (when measuring living standards of a specific country, they must be measured relative to American living standards). As I showed in a post awhile ago, when people complain about America’s stagnant real wages, they are not taking into account rising standards of living for Americans and increased purchasing power. Venezuela may have positive inflation-adjusted wages, but what good is that if the standards of living are really awful (empty shelves in food stores, spoiled food, no electricity, no running water, etc.).

But what if US dollar plunges? This will make imports more expensive–boosting the CPI and thus inflation to some degree. If Europe can replicate the same standards of living as America, but cheaper, then gold is a good hedge against a falling US dollar relative to the Euro and Pound. This was the case in 2002-2011 when gold, the Euro, and the Pound all rose together. European buying power and standards of living were boosted by their strong currency. But in 2011, and continuing to this very day, six years and counting, the US dollar has done very well, and gold has done poorly.

OK, but what about Trump, 2013, and gold failing to hedge against rising anticipated inflation and rate hikes? Again, going back to this quote:

Notice how I use the words ‘inflation’ and ‘interest rates’ almost interchangeably–but this is wrong–they are not interchangeable, although are often correlated. This key subtlety underlies why golds fails so badly for Americans who buy it as a hedge.

As the Venezuela example shows, gold becomes more attractive when present inflation exceeds expected inflation. For Americans who hold gold as a hedge, what matters is not the inflation itself but the inflation relative to interest rates. Trump winning jacked-up future rate hike expectations, but inflation itself didn’t go up much. The market perceives the spending under the Trump administration to be more inflationary for interest rates than expansionary for CPI, which makes long-dated bonds less attractive, but the CPI itself won’t go up that much, because the spending won’t boost GDP growth that much relative to the deficits. This makes gold less attractive, because the actual inflation (CPI) itself isn’t going up that much, just the interest rates are.

The Taylor Rule is important here–if the fed is ‘behind the curve’ (inflation exceeding interest rates), gold can be a good hedge. If the US CPI is 20% and interest rates are 10%, yeah, gold prices should rise. This is why economic stimulus, counterintuitively, is bad for gold holders, because it boosts interest rates but not inflation, because stimulus spending doesn’t boost the economy that much, only debt. Rising interest rates makes cash more attractive. If you have 10% CPI inflation but 20% interest rates, gold becomes less attractive than if reversed. 2013 is another example…the taper boosted long-term interest rate expectations, but actual inflation itself didn’t go up. The market had no reason to expect inflation to rise, and thus perceived the Bernanke fed as being to hawkish. As a result, TIPs, medium & long-dated treasury bonds, and gold all fell significantly in 2013, but short-term treasury bonds (1-3 years) did not fall much, because the fed was not expected to raise interest rates much within the next 2-3 years. Yes, even TIPs are not a good hedge, because like gold, TIPs only hedge against rising CPI-based inflation, not rising interests rates.

In mid-2016, after Brexit, gold surged despite the Brexit being deflationary, because after brexit, because the US economy and stock market didn’t contract much, the expectation was that the fed would be ‘behind the curve’ in delaying rate hikes due to Brexit, but otherwise US economic growth was unchanged.

But also, after Trump won, the dollar surged, because higher interest rates makes the dollar more attractive, further hurting gold (because a rising dollar makes imports cheaper and lowers CPI, thus is deflationary). But in 2002-2007, the dollar fell and interest rates rose, but this was because hedge funds were buying the Euro, Pound and other foreign currencies in anticipation of a foreign economic boom that never came (these funds lost a ton of money in 2008, 2011, and 2013).

Between 2009-2011, the CPI was around 2% but interest rates were less than .25%, which is why gold did well–the fed was behind the curve.

In conclusion, for Americans who buy gold as a hedge, it’s only effective as a hedge if: the US dollar falls a lot like it did in 2002-2011–and or–if the fed is perceived as behind the curve in tackling CPI-based inflation. Gold will not preserve capital if CPI-based inflation is expected to be low relative to interest rates; in such an instances, short-duration bonds and notes are better. If Trump’s stimulus plans are passed by Congress, gold will likely take a hit, to the dismay of those who are expecting gold to hedge.