Will Gold Save You From Inflation?

Summary

• With inflation reaching eye-watering levels in Europe and the US, some look to gold as an inflation hedge.
• Three important factors drive gold’s price: long-term real interest rates, the long-term cost of energy, and risk aversion.
• The recent start of the Fed hiking cycle, plus the risk that a coming recession could lead to disinflation, leave considerable uncertainty around real interest rates.

Market Implications

• We are neutral on gold, but we see upside in agricultural commodities on the back of the Russia-Ukraine crisis.

Inflation Is Soaring

The last time the US saw inflation this high was four decades ago. And while at a staggering 7.9% for February, surging energy costs from the Russia-Ukraine war will likely push March’s CPI data (out on 12 April) even higher. Europe is likewise: Italy hit 7% for March, Germany 7.6%, and Spain an eye-watering 10%.

How do you invest in such an environment? Economists and investors continually squabble over the best inflation hedges. Seasoned practitioners at Man Group recently argued for commodities and collectibles as the best option. A recent IMF working paper suggested equities, while historically a poor inflation hedge, have become less sensitive to inflationary news. And billionaire investor Paul Tudor Jones even touted bitcoin as the way to go.

Remember Gold?

With all the crypto mania and the wild swings in oil (it just saw a decade’s worth of volatility in five weeks), it is easy to forget that commonly proposed defence against inflation: gold.

Recent research by the World Gold Council suggests gold struggles to perform in the short term during inflationary periods. However, its analysis of the last 50 years revealed gold’s price rose 14% on average in years when inflation was over 3%. But what factors affect the price of gold?

What Drives Gold Prices?

When inflation first started ticking up in July 2021, we spoke to leading commodities expert and  macro strategist John Butler. He argued that gold has three primary drivers: long-term real interest rates, the long-term cost of energy, and risk aversion.

How Interests Rates Drive Gold Prices

As Butler explains, ‘long-term real interest rates are the single most important factor. They are, after all, the long-term real-time value of money, and so a stable monetary commodity such as gold should naturally have a very strong relationship with that in the medium to long term, and it does.’

The Gold-Energy Link

The second driver of gold prices is the long-term cost of energy – specifically long-dated oil prices. The recent Russia-Ukraine crisis will likely push the green transition into overdrive to reduce Western dependency on Russian oil exports. However, gold mining still depends on oil. As Butler puts it,

‘Anyone who knows the first thing about precious metals mining knows that the single most important thing in terms of digging a big hole in the ground, be it shallow and wide or deep and narrow, is to have enough local power available, and you have got to build a power plant. There’s just no other way to do it. And that power plant is overwhelmingly going to be oil and gas powered. That’s just the way the world works.’

Gold as a Safe Haven

And the third driver of gold is risk aversion. During periods of high economic certainty, investors tend to flood to traditional risk markets such as equities to gain higher returns. But during periods of great uncertainty, a flight-to-quality can drive investors to save-haven assets such as gold.

Are All the Ducks Lined Up?

Butler argues that to turn bullish on gold, you need all three factors to align. Oil prices must be rising, risk aversion must be elevated, and central banks must follow a negative real interest rate policy.

Arguably, two of those factors are in place. Although volatile, oil has risen from under $20/bbl in March 2020 to around $100/bbl in the last month. And Macro Hive sees further upside. Meanwhile, the CBOE Volatility Index (VIX), which measures market expectations of future volatility – and is therefore arguably a gauge of uncertainty – has remained above its pre-Covid lows.

But what about real interest rates? At the end of 2021, surging inflation pushed real inflation rates even deeper into negative territory for developed economies: -5.3% for the US, -3% for the UK, and -4.6% for Germany. And real rates deepened the more inflation rose and the longer central banks remained reluctant to tighten too aggressively.

Yet on 16 March 2022, Fed Chair Jerome Powell pulled the policy trigger. For the first time in three years, the Fed approved a 25bp hike. Rates markets now price eight more hikes by the end of the year. And Powell followed up the move with a statement about hiking even more aggressively if necessary to curb inflation. The Bank of England is tightening too, enacting its third consecutive hike and signalling another in May.

Meanwhile, with the US yield curve (2s10s) close to inverting, speculation abounds that the US could enter a recession in the next 12 months. If that happens, inflation could slow and possibly turn into outright deflation. Consequently, the outlook for real interest rates is hardly certain.

The Macro Hive Position

At Macro Hive, we are firmly neutral on gold right now. We see more opportunity in other commodities. For example, as the Russia-Ukraine crisis plays havoc with markets, fertilizer prices have soared. One way to gain exposure is agricultural commodities. They face upward price pressure while agricultural sanctions persist, and investors can hold corn and wheat via ETFs to benefit.

Matthew Tibble is Commissioning Editor at Macro Hive. He has worked as an editorial consultant and freelance editor for companies such as RiskThinking.AI, JDI Research, and FutureScape248.