Gold Hedge Not Working?

A couple of quick things today:

1) Just wanted to take the chance and thank Shawn again for the many insights over the last year or so. I thoroughly enjoyed and learned from your posts. With that said, I will do my best to try and keep this blog going while juggling my current work responsibilities.

I've also personally grown through the feedback and reverberation of thoughts after my various posts and would encourage those who are interested in developing or sharpening their macro/trading analytical abilities to email the original macro man: mrmacro -at- gmail.com

2) I wanted to quickly note one point: Gold in USD terms has failed to be an optimal hedge for the most recent move in inflation expectations.

I've done a more in-depth study on gold as an inflation hedge in a past post here. I wanted to reemphasize some of those dynamics, as they seem to be at work.

Many people buy gold as a hedge for inflation expectations. That doesn't always work. The real yield has held steady and has even risen as of late - if this persists, it will be very difficult for gold to catch a bid.

Conversely, people expect inflation to be hampered if the real cost (inflation adjusted cost) of borrowing is rising. However, that is also a fallacy. Market inflation expectations are calculated via the spread between nominal bonds and inflation-linked bonds. As long as the nominal yield is rising faster than the real yield, you would, in essence, be witnessing a market expansion of inflation expectations.

However, as previously mentioned, the rising real yield would be a damper on Gold prices.

The market since the beginning of 2018 has validated this theory. There are potential scenarios for this phenomenon of flat or declining gold prices to coexist with rising market inflation expectations into the future.  For example:

- Imagine a world with persistently rising inflation (this scenario is much less controversial now than even 6 months ago). 
- Central banks are now inclined to lean on the hawkish side to combat inflation (this belief is much more prevalent now than even a year ago). 
- However, global central banks are "not allowed" to raise rates fast enough because there is so much debt floating around. A combination of increases in supply (increased treasury issuances for example), and rising inflation expectations, the bond market finally has the "ah ha!" moment by selling nominals en mass. 
- The Fed cannot let real rates rise as rapidly as nominals, as it would hamper borrowing costs too much and make the existing debt incredibly difficult to service. Nevertheless, the Fed must let the real rate trend higher slowly as there is still a need to combat inflation.

The end result? Lower gold prices and higher breakeven inflation.

All-in-all, gold can be a good inflation hedge at certain times, but buyer beware - warning signs are evident.

Good luck,

DR