Case Study: Can Gold Rally Along With Inflation?

So I woke up a few days ago and saw this WSJ piece.

Yes, world; letting real rates stay negative for so long was probably going to do that.

I thought it would be a good excuse to compose another thought piece. Like the kids say: here goes nothing.

Now we've detailed potential drivers for inflation in the past - with oil ripping towards new highs (Saudi-corruption-purge-driven or not), nominal rates ripping higher, and stocks falling, I was curious to also see gold also down.

I am a strong believer that gold trades like a currency rather than a commodity. Commodities for the most part trade based on supply and demand. The demand function is usually the result of end-use products that during special situations may be propelled further by speculative fervor.

Oil gets turned into gasoline and put into vehicles, grains, softs, meats get eaten, metals get thrown together to make cool stuff, etc. etc.

The supply function, in many aspects, behaves in accordance with price. Price goes higher, people invest in getting more of that high price "stuff" whatever it may be and vice versa.

Gold is a bit different. Why? Like all commodities, it can store some value. But the key difference here is the fact that global central banks, those crazy economic professor types, deem it as a viable form of storer of value and medium of exchange so much that they accumulate it as reserves.

As a result, gold more than any other precious metal trades like a currency based on the rates of the country that it's denominated in.

So here we are at the focal investigation of the post. Hypothetically, if inflation rises (let's not argue this right now and just assume such is the case), will gold be a good hedge? 

Let's go to the charts first, since I'm lazy.

Yes, yes I know - I didn't get the chance to run the regression on returns vs returns - I have a very finite window to use BBG and the files I build I cannot keep. On top of that, without a BBG API, it takes a horrific amount of time to manually extrapolate the real yield (before the existence of TIPS) by interpolating the CPI.

With my whining aside, even with an "incorrect" price vs price regression - you can observe the directional relationship between gold and those rates. Also, the relative relationship between the different rate products vs gold should be valid as well (the base effect from the regression of price vs price as a result of the level differences should be somewhat negated as all the rate products are roughly on the same base level).

Spot gold px vs real yield shows the tightest connection here. So we'll focus in on that one for a sec.

From the above, it is evident that gold goes down when real yields go up in a semi-lockstep fashion. (I assume the economic driver here is: holding gold which yields nothing vs holding a currency which in some situations can yield a lot in real terms and in other situations can yield very little or even negative in real terms)

Conclusion 1 - Gold trades rather closely with real yields. Although there are sure to be other factors influencing the gold price, it is roughly over the long term a function of real yields.

Moving along. Assuming the answered found in Conclusion 1. Can gold always be a good hedge for inflation? Or better yet, can real vs nominal yields diverge (widening of breakevens and thus the emergence of "inflation") without real yields actually going up significantly (real yields going up would theoretically put significant downward pressure on gold)

Let's look at some different yield regimes. 

The two main interests that occupy my focus for this experiment. They are the high inflation periods of the 70's and 80's as well as the periods of shock post the dot-com bubble and the GFC.

Now I'm going to add some events to shed some qualitative light on the various worldly happens which caused individual reactions to rates. 

FYI, for those with a short attention span - this will be a very long table. I will highlight in red those times when real rates were likely zero or negative (higher inflation vs fed funds rate) and I will also provide a summary at the bottom.

Disclaimers: 

The inflation prints were averaged out for entire years while the Fed Funds rate is printed on the table only when a change occurs. Basically, this analysis is far from perfect. 

However, assuming that those highlighted periods were times when real rates were either negative or close to zero is probably semi-safe. Besides, what's life without the right amount of danger, eh?

Those with the curiosity of a cat and armed with a Bloomberg terminal can hopefully use this as a launch pad for additional analysis.

Date	Fed Funds Rate	Event
Fed Chair Arthur Burns (January 1970 - March 1978)
1971: GDP = 3.3%, Unemployment = 6.0%, Inflation = 3.3%
Jan	4.5% - 4.0%	Expansion.
Feb	3.5%
Jul	5.5%	Fed raised rate to fight inflation.
Aug	5.75%	Wage-price controls.
Nov	5.0%	Lowered rate to stimulate growth.
1972: GDP = 5.2%, Unemployment = 5.2%, Inflation = 3.4%
Mar	5.5%	Raised rate to combat inflation. Confused markets.
Dec	5.75%
1973: GDP = 5.6%, Unemployment = 4.9%, Inflation = 8.7%
Jan	6.0%	Raised four times that month.
Feb	6.75%	Lowered to 6.5%, then raised to 6.75%.
Apr	7.25%	Raised for next five months.
Aug	11.0%	OPEC embargo created inflation in October.
1974: GDP = -0.5%, Unemployment = 7.2%, Inflation = 12.3%
Feb	9%
Jul	13%	Raised from March to mid-July.
Dec	8.0%	Lowered gradually from July to December.
1975: GDP = -0.2%, Unemployment = 8.2%, Inflation = 6.9%
Jan	6.5%	Lowered four times in January.
May	5.0%	Lowered five times in five months.
Sep	6.5%	Raised from June through September.
1976: GDP = 5.4%, Unemployment = 7.8%%, Inflation = 4.9%
Jan	4.75%	Lowered from October through January.
Apr	5.5%	Raised in April and May.
Nov	4.75%	Lowered from July - November.
1977: GDP = 4.6%, Unemployment = 6.4%, Inflation = 6.7%
Aug	6.0%	Raised from December through August
Oct	6.5%	Raised again in September and October.
Fed Chair William Miller (March 1978 - August 1979)
1978: GDP = 5.6%, Unemployment = 6.0%, Inflation = 9.0%
Jan	6.75%
Dec	10.0%	Raised each month from April through December.
Fed Chair Paul Volcker (August 1979 - August, 1987)
1979: GDP = 3.2%, Unemployment = 6.0%, Inflation = 13.3%
Apr	10.25%
Oct	15.5%	Raised rates 4 points.
Dec	12.0%	Gradual decline through the month.
1980: GDP = -0.2%, Unemployment = 7.2%, Inflation = 12.5%
Jan	14.0%	Increased rapidly that month.
Mar	20.0%	Raised rates in February and March.
Jun	8.5%	Lowered to 9.5% in May and 8.5% in June.
Sep	12.0%	Rates increased to 10.0% in August and 12.0% in September
Dec	20.0%	Raised steadily until mid-December.
Dec 29	18.0%	Lowered two points.
1981: GDP = 2.6%, Unemployment = 8.5%, Inflation = 8.9%
Jan	20.0%	Reagan took office. Volcker raised rates again.
Apr	16.0%	Lowered 4 points.
May	20.0%	Raised 4 points.
Dec	12%	Lowered 8 points.
1982: GDP = -1.9%, Unemployment = 10.8%, Inflation = 3.8%
Apr	15.0%	Raised 3 points.
Dec	8.5%	Lowered nine times over nine months.
1983: GDP = 4.6%, Unemployment = 8.3%, Inflation = 3.8%
Aug	9.66%	Raised from May to August.
Oct	9.25%	Lowered from August to October
1984: GDP = 7.3%, Unemployment = 7.3%, Inflation = 3.9%
Aug	11.75%	Raised from March to August.
Dec	8.25%	Lowered from September to December.
1985: GDP = 4.2%, Unemployment = 7.0%, Inflation = 3.8%
Mar	9.0%	Raised from February to mid-March.
Dec	7.75%	Lowered from April to December.
1986: GDP = 3.5%, Unemployment = 6.6%, Inflation = 1.1%
Aug	5.66%	Lowered from March to August.
Dec	6.0%
Fed Chair Alan Greenspan (August 1987 - January 2006)
1987: GDP = 3.5%, Unemployment = 5.7%, Inflation = 4.4%
Sep	7.25%	Raised rates from April to September.
Nov	6.75%	Lowered after October 19 stock market crash.
1988: GDP = 4.2%, Unemployment = 5.3%, Inflation = 4.4%
Feb	6.5%	Lowered in January and February.
Dec	9.75%	Raised rates to fight inflation.
1989: GDP = 3.7%, Unemployment = 5.4%, Inflation = 4.6%
Dec	8.25%	S&L crisis. Fed lowered rates.
1990: GDP = 1.9%, Unemployment = 6.3%, Inflation = 6.1%
Dec	7.0%	Recession began in July.
1991: GDP = -0.1%, Unemployment = 7.3%, Inflation = 3.1%
Dec	4.0%	Recession ended in March.
1992: GDP = 3.6%, Unemployment = 7.4%, Inflation = 2.9%
Apr 9	3.75%	Expansion.
Jul 2	3.25%
Sep 4	3.0%	Clinton took office in 1993. Fed made no changes.
1994: GDP = 4.0%, Unemployment = 5.5%, Inflation = 2.7%
Feb 4	3.25%
Mar 22	3.5%
Apr 18	3.75%
May 17	4.25%
Aug 16	4.75%
Nov 15	5.5%	Raised rates.
1995: GDP = 2.7%, Unemployment = 5.6%, Inflation = 2.5%
Feb 1	6.0%	Raised rates.
Jul 6	5.75%	Lowered rates.
Dec	5.5%
1996: GDP = 3.8%, Unemployment = 5.4%, Inflation = 3.3%
Jan 31	5.25%	Kept rates low despite inflation.
1997: GDP = 4.5%, Unemployment = 4.7%, Inflation = 1.7%
Mar 25	5.5%
1998: GDP = 4.5%, Unemployment = 6%, Inflation = 1.6%
Sep 29	5.25%	LTCM crisis.
Oct 15	5.0%
Nov	4.75%
1999: GDP = 4.7%, Unemployment = 6%, Inflation = 2.7%
Jun 30	5.0%	Raised rates
Aug 24	5.25%
Nov 16	5.5%
2000: GDP = 4.1%, Unemployment = 6%, Inflation = 3.4%
Feb 2	5.75%	Raised rates despite stock market decline in March.
Mar 21	6.0%
May	6.5%
2001: GDP = 1.0%, Unemployment = 6%, Inflation = 1.6%
Jan 3	6.0%	Bush took office.
Jan 31	5.5%
Mar 20	5.0%	Recession began. Fed lowered rates to fight it.
Apr 18	4.5%
May 15	4.0%
Jun 27	3.75%	EGTTRA tax rebate enacted.
Aug 21	3.5%
Sep 17	3.0%	9/11 attacks.
Oct 2	2.5%	Afghanistan War.
Nov 6	2.0%
Dec 11	1.75%
2002: GDP = 1.8%, Unemployment = 6%, Inflation = 2.4%
Nov 6	1.25%
2003: GDP = 2.8%, Unemployment = 6%, Inflation = 1.9%
Jun 25	1.00%	JGTRRA tax cuts enacted.
2004: GDP = 3.8%, Unemployment = 6%, Inflation = 3.3%
Jun 30	1.25%	Low rates pushed interest-only loans. Helped cause Subprime Mortgage Crisis.
Aug 10	1.5%
Sep 21	1.75%
Nov 10	2.0%
Dec 14	2.25%
2005: GDP = 3.3%, Unemployment = 6%, Inflation = 3.4%
Feb 2	2.5%	Borrowers could not afford mortgages when rates reset in 3rd year.
Mar 22	2.75%
May 3	3.0%
Jun 30	3.25%
Aug 9	3.5%
Sep 20	3.75%
Nov 1	4.0%
Dec 13	4.25%
Fed Chair Ben Bernanke (February 2006 - January 2014)
2006: GDP = 2.7%, Unemployment = 6%, Inflation = 2.5%
Jan 31	4.5%	Raised to cool housing market bubble. More homeowners default.
Mar 28	4.75%
May 10	5.0%
Jun 29	5.25%
2007: GDP = 1.8%, Unemployment = 6%, Inflation = 4.1%
Sep 18	4.75%	Home sales fell.
Oct 31	4.5%
Dec 11	4.25%	LIBOR rose.
2008: GDP = -0.3%, Unemployment = 6%, Inflation = 0.1%
Jan 22	3.5%
Jan 30	3.0%	Tax rebate.
Mar 18	2.25%	Bear Stearns bailout.
Apr 30	2.0%	Lehman fails. Bank bailoutapproved. AIG bailout.
Oct 8	1.5%
Oct 29	1.0%
Dec 16	0.25%	Effectively zero. The lowest fed funds rate possible.
Fed Chair Janet Yellen (February 2014 - January 2018)
2015: GDP = 2.6%, Unemployment = 6%, Inflation = 0.7%
Dec 17	0.5%	Growth stabilized.
2016: GDP = 3.2%, Unemployment = 4.6%, Inflation = 0.4% (as of December, 19 2016)
Dec 14	0.75%
2017: GDP, Unemployment and Inflation TBD
Mar 15	1.0%	Fed projects steady growth.
Jun 14	1.25%

Whoa, that was a lot of blog space. If you want a descriptive version of what happened - here's an NY Times article.

So to summarize some of the events in the table, we have a few periods of interest. You have 1973 - 1979 where there were often times when real rates were either negative or close to being negative. Same can be said about 2004 - 2005 and then 2008 where real rates were negative at the end of the year. - 2016.

I believe monetary stimulus is much more effective (perhaps, only effective) when there is fiscal stimulus implemented in a concurrent fashion.

Here is a chart of long-term government spending.

If you carefully look, I saw spikes in government spending relative to government receipts in 1975-1977, what looks to be around 1987, 1992, 2001, and then 2009. Therefore, I expect those times, if combined with low/negative rates to create a sizable amount of inflation.

The opposite trend could be said from the mid-1990's to 2000. I would expect low inflation during this period especially if real rates were positive.

Now tying it all together with the gold price. I have three screenshots. 

Rates: Nominal vs Real in different "regimes"

Spot gold prices in corresponding "regimes"

My weekly data for gold doesn't go back that far - so here is the chart for the first "regime (1975 to 1985) in monthly spot gold prices.

1975 - 1985

As you can see from the above: our data starts with gold falling close to ~50% (from 180 to below 100) from 1975 to late 1976 as real yields rose against steady nominals (a closing of the breakeven inflation). 

Then, we experienced something extraordinarily scary - a rise in nominal yields with a falling real yield from 1978 to 1980. This development of inflation along with real yields actually trading lower led to an explosion in gold prices (trough to peak move of ~400% in one year) - proving that gold was indeed a good inflation hedge in this scenario. Finally, real yields marched higher along with nominals and gold went into a huge bear market.

So yes, there can be a bond bear market (nominal rates rising) while there is a breakout in inflation - during which gold would be a great hedge. However, interestingly, even with low rates and inflation during the early and mid-1970's, gold actually fell ~50%. Remember, 1975 we had the increase in government spending as noted above. In addition, we had close to negative real rates.

It seems that the direction of the real yield and the general direction of inflation actually caused gold prices to fall despite the absolute level of inflation was still high. 

Bretton Woods and the oil shock were monumental events that contributed to all asset classes in this period. I'm not an expert on either of those subjects, so I will leave any potential contributions & impact of those events to this price action to you guys.

1985 - 1996 

Moving on to the next time bucket. 1985-1996 saw a rally in gold from 1985 to 1988 coming out of the bear market. 1986 - 1987 saw a small pocket of breakeven inflation going higher, potentially triggering gold higher as well. 

Interestingly as nominal rates continue to fall in the beginning of the 1990's - real rates roughly stay the same. Gold did not trade closely with real rates in this scenario and instead tracked breakeven inflation as both kept getting squeezed lower. 

Lastly, you had meaningful moves in nominals and real yield first higher, then lower in 1994 to 1996. Gold ultimately did not care as it stayed tightly range bound.

1996 - 2009

A quick side note: of the 4 rates charts in the real vs nominal screenshot above, this regime's chart actually has the red line as the real yield and blue as the nominal - sorry for any confusion.

Continuing with the decrease in government spending and generally low inflation of the mid-1990's - gold continues to slide, goes nowhere.

Then, when we hit the 2000's, we started to see both nominals and real yield go lower. This move was roughly in tandem so I don't think breakevens were moving much. With a slight expansion of breakevens and inflation itself not really trading directionally despite lower rates and increased government spending, gold's reaction was to steadily build into a bull market.

In my opinion, this move in gold in the 2000's could be explained by persistently lower real yield. Inflation had risen slightly but it was nothing significant and definitely dwarfed by the move in gold.

Lastly, we have 2008 - 2009. Real yields spiked higher while inflation collapsed - gold subsequently sold off, tracking both inflation and real yields pretty well.

2009 - Present

Post GFC, the most interesting period of time was late 2011 to 2013. Nominals started to bottom out while real yield continued to march lower. We began building higher lows in breakevens as inflation looked poised to go higher. 

This actually proved to be the peak in gold. As real yields spiked higher in what was later deemed the taper tantrum with gold going into bear market ever since.

Conclusion 2: After all that rambling, here's to summarize: I think gold is probably less of an inflation hedge than some might think. Although it does follow inflation to an extent - gold also seems to be very sensitive to real yield moves. If you believe real yields are set to rise along with inflation - then gold might not necessarily do very well - for example, 1981-1982, gold kind of topped out despite the fact that there was still pretty high inflation simply because real yields were rising.

But then, you have scenarios such as the early/mid-2000's with low and steady inflation, with a consistently lower real yield, where we also witnessed the foundation of a huge gold bull market.

And ultimately, there are scenarios of higher nominal yield and lower real yield - usually, they are ephemeral, lasting only a few months. However, we saw a meaningful one that lasted from 1978 to 1980. 

Keep in mind as with many things in the market, it seems that direction mattered more often than level. For example, when the widening of real and nominal rates in 1980 hit its zenith, gold was already peaking. 

Other miscellaneous charts for your musings:

Here's FED and ECB assets vs spot gold price

Here's gold vs the VIX

I think our own Macro Man did a little bit of analysis on that one as well. I'm sure all the readers have seen that one, but in case you haven't, here it is - linked here.

And that's all I got this go-round, guys.

Hope everyone has a wonderful day and weekend. Stay warm out there!