SPENGLER Gold and bonds as options on the
inflation rate By Spengler
Investors generally misunderstand gold. It
is not a hedge against inflation, not, at
least, against the sort of inflation we see in
store prices. This becomes clear when we compare
the gold price to the two components of the
10-year Treasury yield, namely the yield of
inflation-indexed Treasuries (TIPS) vs the
so-called breakeven inflation rate, that is, the
yield difference between ordinary coupon
Treasuries and TIPS.
We observe almost no
relationship between gold and breakeven inflation
expectations embodied in the 10-year yield, but an
extremely close
relationship between gold and the
inflation-protected Treasury yield.
Exhibit 1: Gold vs 10-year
TIPS (left-hand scale) and 10-year break-even
inflation (right-hand scale), daily
data from February 2, 2006 to February 2, 2012 Source: FRED, World Gold Council.
The r-squared of regression between
gold and TIPS yields during the past five years is
a remarkable 87%. Between gold and breakeven
inflation, it is zero. Nonetheless, economists,
commentators and financial advisers insist on
referring to gold as an inflation hedge.
We find a solution to the puzzle when we
cease to view expectations as a fixed point but
rather as a range of possibilities. Gold is not a
measure of the future price level, but an undated,
out-of-the-money put option on the US dollar's
reserve role. Bonds (especially inflation-indexed)
are an option on prospective inflation.
The fact that the value of both these
forms of optionality is rising tells us that
markets are extremely uncertain as to whether we
will have inflation or deflation. Investors pay up
for hedges on both. That is the theory; empirical
observation strongly supports the textbook.
The market is suffering from something
like Margaret Dumont's double blood pressure in
the Marx Brothers' classic A Day at the
Races. Fiscal strains in most of the major
industrial countries might lead to inflation on
the Latin American model, or deflation on the
Japanese model.
Deflation can arise from
fiscal strains when governments are unable to
borrow and are forced to cut expenditures
drastically, for example, the southern European
countries in the context of the European Union. If
these countries leave the eurozone, revert to
their old national currencies, and turn on the
printing presses, the result could well be
inflation.
The 10-year inflation-indexed
Treasury pays a negative yield of 40 basis points.
If inflation remains where it is now, investors
get back less principal than they invested. They
are willing to buy into a loss in order to be
insured against an unexpected jump in the
inflation rate.
Gold tracks TIPS much more
closely than coupon Treasuries, because it also
represents an option on inflation.
Investors suffer from one-dimensional
thinking; the market is not betting on a specific
score, but rather on the point spread. The risk of
an extreme change in the value of money motivates
investors to pay a negative yield to own TIPS, and
to own a sterile asset in the form of gold.
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