Thave wheels a phrase that describes how unpredictable financial markets can be: “better off being stupid”. Stocks or other financial markets can sometimes behave in unpredictable ways. Analysts predicted that if Donald Trump won the 2016 election, US stock prices would plummet – they soared. Share prices sometimes fall for companies that are making better-than-expected earnings. Looking ahead should give a trader an edge, and in most cases it does. But not always.
Suppose you knew at the start of 2021 that inflation was about to skyrocket due to rampant central bank money printing and extravagant fiscal stimulus. In addition, you may also have known that inflation would then be fueled by infighting in Europe. Knowing this, there may be one asset above all others that you would have poured your savings into: the precious metal that graces the necks and wrists of the wealthy in countries where inflation is a constant problem.
Then it’s better to be stupid. The price of gold has barely moved in two years. On January 1, 2021, an ounce cost just under $1,900. Today it costs $1,960. You would have made a princely profit of 3%.
What’s up? Finding the right gold price is a difficult task. Gold fans point to the metal’s historical role as a back-up asset, its use in fine jewelry, its limited supply, and its physical durability as reasons why it retains value. Because at first glance, the phenomenon is strange: unlike stocks and bonds, gold generates neither cash flows nor dividends.
But this lack of revenue is also indicative of the metal’s mediocre earnings in recent years. Because gold does not generate cash flows, its price tends to be inversely correlated with real interest rates – when safe, real yields, such as those on government bonds, are high, non-cash flow generating assets become less attractive. For all the excitement about rising inflation, the rise in interest rates was even more notable. As a result, despite the rise in inflation, long-term expectations remained surprisingly well anchored. The 10-year government bond yield, net of a measure of inflation expectations, has risen from around -0.25% at the start of 2021 to 1.4% now.
In 2021, researchers at the Federal Reserve Bank of Chicago analyzed the main drivers of gold prices since 1971, when America abandoned the gold standard, a system by which dollars could be converted into gold at a fixed rate. They identified three categories: gold as a hedge against inflation, gold as a hedge against economic disasters, and gold as a reflection of interest rates. They then tested the price of gold using annual, quarterly and daily data against changes in inflation expectations, attitudes towards economic growth and real interest rates.
Their results suggest that all of these factors do affect the price of gold. The metal appears to offer a hedge against inflation and price increases when economic conditions are gloomy. Most compelling, however, has been the evidence of the effect of higher real interest rates. The negative effect was evident regardless of the frequency of the data. In the 1970s, 1980s, and 1990s, inflation was perhaps the most obvious driver of gold prices, but from 2001, the researchers noted, long-term real interest rates and views on economic growth dominated. The way gold prices have moved since 2021 seems to support their conclusion: inflation matters, but real interest rates matter most.
All of this means that gold could serve as an inflation hedge – but inflation isn’t the only variable that matters. The metal’s price will rise during periods of inflation, when central banks sleep at the helm and real interest rates fall, or when investors lose confidence in policymakers’ ability to regain control of the metal. So far in this inflation cycle neither has happened.
A little knowledge of the future can be dangerous. The Gap in the Curtain, a science fiction novel by John Buchan published in 1932, is a story about five people who are chosen by a scientist to take part in an experiment that gives them a glimpse of a year in the future should enable future. In the end, two see their own obituaries. According to Hugh Hendry, a Scottish hedge fund investor, it is the “best investment book ever written” because it encourages readers to imagine the future while also thinking deeply about what exactly is causing certain events. As recent, seemingly confusing moves in gold prices show, floating about the future is a dangerous habit.■
Read more from Buttonwood, our financial markets columnist:
Can anything burst the everything bubble? (4th of July)
Americans love American stocks. You should look abroad (June 26)
Why investors can’t agree on the financial outlook (June 22)
Also: Like the Buttonwood Column got his name
