Can Gold and Bond Yields Rise in Unison?
Thursday, 25 March 2021
Anyone who follows gold on a regular basis would have noticed the current obsession with the US 10 Year bond yield, with each tick higher or lower corresponding with a very strong inverse correlation in the gold price. A lot of media commentary has been around the fact that this trend of rising bond yields could mean the death of gold, and that higher bond yields are seen to be a negative when you factor in the opportunity cost of holding zero yielding gold. But there is something more to the story which we will cover in this week’s update as we attempt to answer the question: can bond yields and gold rise at the same time?
For those without the patience to read this week’s update, the answer is ‘yes’, but it all depends on one thing: inflation. With bonds having been through an almost uninterrupted 40-year bull market, there are few periods of significance where bond yields have risen for an extended time in recent years; however, we will look at these periods and compare how gold performed in retrospect.
The first noticeable period would be during the economic boom pre-GFC where the US 10Y yield rose from a low of 3.2% in 2003 to a high of 5.2% in 2007, whereas gold in USD terms still managed to rise from under $400 per ounce to over $650 in the same time frame
US 10Y Yield (2003 to 2007)
Gold Price in $USD (2003 to 2007)
We can see that there is no economic law that states bond yields and gold cannot rise at the same time, so perhaps the fear around rising bond yields is misguided. If we wind the clock back further, we can take a look at the best example of a period of significantly higher bond yields and interest rates, and that is the inflationary period of the 1970’s. An incredible period of time from a number of perspectives, and many gold investors would remember the end of the gold standard in August of 1971.
The following three charts show the yield on 10-year Treasuries, the gold price in USD terms, and the inflation rate at the time.
US 10Y Yield 1970’s
Gold Price in $USD 1970’s
US Inflation 1970’s
From 1972 to 1982, the yield on US 10Y Treasuries rose from 6% to 15%, the Federal Reserve cash rate went from 5% to 20%, and Gold rose from $50 an ounce to above $650 an ounce in the same timeframe. That’s over 1,000% returns for gold in $USD despite the dramatic rise in interest rates and bond yields.
It is quite clear in the above example that interest rates, bond yields and gold can all rise in unison during an inflationary period. There is nothing to say they must be uncorrelated at all times. The ‘real yield’ is more important, which would be the return on bonds after factoring in inflation. Inflation fears would also have exacerbated buying psychology in the 70’s, leading gold to outperform even further during this period, which means the rise in gold not only protected purchasing power but had strong ‘real returns’ after inflation being considered.
What is happening right now is the fixation of the US 10Y yield and gold prices, but markets often get fixed on one correlation to the next for short periods of time before the correlation ends and something else (such as rising inflation) starts to dominate buying or selling behaviour. We can remember when the gold market was fixated on the ‘trade wars’ between Trump and China, and the price jolted up and down with every small piece of trade war news. Previous to that you had Brexit or the Trump election. Geopolitical events also tend to take centre stage when it comes to gold price direction; however, right now the fixation is the rising 10Y yield, but it won’t last forever.
One important thing to note here: if we did see inflation running out of control in years to come, there is almost zero risk in owning gold, as it would have an incredibly high percentage chance of performing well under that environment. What is the risk in holding a broad exposure to highly indebted companies, and US corporate debt is currently sitting at over $10 Trillion.
If you’re holding stocks in companies that are debt free, higher inflation may not pose a risk at all. Resource companies with strong balance sheets and minimal debt for example would likely do very well, so long as commodity prices were rising. However, if you’re holding shares in companies with very large liabilities and not strong underlying earnings (basically the most popular stocks of 2021) these companies could come under a lot of pressure if rates are forced higher to combat inflation and could risk bankruptcy depending on how high rates rise in response. Pretty soon popular growth companies with no actual earnings and huge liabilities could go from being market darlings to being crippled by their rapidly rising cost of debt. The corporate bond market in the US right now is a disaster waiting to happen if interest rates rise, so be careful of anyone telling you to buy the broader US share market if we start seeing inflation rising in a meaningful way.
In fact, let’s look at what the US share market did in this last major inflationary period of 1972 to 1982. In 1972 the S&P500 index was trading at 100, and rose to 140 in 1982 at the peak, but largely tracked sideways and even had a 30% correction early on. Investors during this period, excluding dividends, would have seen returns of roughly only 40% total over 10 years, essentially going backwards when you factor in ‘real returns’ after the high inflation rate of the time.
Clearly you would have been far worse off holding the broader stock market than if you had held gold during the same period. Silver too went from $5 per ounce to $50 at the peak of 1980, before trading back below $5 in years to come.
Many indebted companies that made up the S&P500 in the 70’s would have struggled with rising interest rates and higher costs of debt impacting their earnings. Gold is hands down the number one asset to own in an inflationary period, and not stocks or bonds. Arguably property should get a mention here, as it too can be a great hedge against inflation, but you would want to make sure you own property outright, or with not much debt, as inflation will naturally lead to higher interest rates as that is the only tool Central Banks have in their arsenal to combat it. With Australia sitting on record household debt, the one thing we do not need right now would be runaway inflation forcing the RBA’s hand to raise interest rates significantly in response.
Milton Freidman described in his book Money Mischief: Episodes in Monetary History that inflation is always a “monetary phenomenon” and usually comes about after a significant increase in the monetary base:
“Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”
During the 1970’s President Nixon wanted strong economic growth and low unemployment at any cost and was not concerned about rising inflation. Even breaking the link between the US Dollar and gold. The key money creation indicator the “M1 Money Supply” in the US had a dramatic increase in 1971 as it went from $228 Billion to $249 Billion from 1971 to 1972, or a 9.2% increase in a single year. The M2 money supply, which is a broader index including savings and deposits, rose from $710 Billion to $802 billion, some 12.9% increase in one year. This sharp jump in the money supply is what preceded a runaway inflationary period that eventually led to gold rising 10 times in value and interest rates being forced higher to a massive 20% to stop what could have led to hyperinflation.
Federal Reserve Cash Rate 1970’s
Now let’s compare to today; 2020 saw the largest expansion in the US money supply that has ever happened. The M1 rose from $4 Trillion to $16 Trillion in a year, some 300% and the M2 rose from $15.5 Trillion to over $19 Trillion, or 22% in under 12 months, putting 1971 to shame. If ever there was one chart to get inflation fears stirring it would be the one below, the latest US M1 Money Supply.
It is no wonder that US Bonds are selling off in spectacular fashion, as smart money and foreign investors are already pricing in a big jump in inflation in years to come. You don’t want to be stuck with near 0% yielding government debt if we see inflation start running out of control. But it isn’t just the US money supply that has had a sharp increase, this is a global phenomenon for 2020 and the Australian M2 Money Supply can be seen below up until early 2020, but currently stands at $1.8 Trillion in USD terms as at Jan 2021, a 63% increase in one year.
When comparing the 1970’s to today the most dangerous phrase that comes to mind is ‘this time it’s different’. This time it really is different when it comes to the rapid pace of which new fiat currency has been created from thin air; however, whether or not this unprecedented expansion of the global money supply will create inflation is the debate which is happening among economists today.
With all the monetary stimulus of the past decade not yet impacting the CPI, the main reason for this has been the falling ‘velocity of money’. Money Velocity (the pace at which it changes hands, and is usually an effect of aggregate demand) has been plummeting, as most of the monetary stimulus hasn’t flowed through to the broader economy (or bottom 90%). With Biden’s stimulus package, this changes things as some of the newly created money is going straight into the hands of everyday Americans. If money velocity has in fact bottomed, and starts to rise from here, then we should all be very concerned with what is to come.
The Federal Reserve’s commentary of late has been quite dovish when it comes to inflation, even Nixon-esque, stating they are happy for the CPI to rise above target for some time before being concerned. The trouble is, when inflation moves beyond a desirable level and starts spiralling out of control it can become a central banker’s worst nightmare. Given the size of the current expansion of the global money supply in such a short space of time, this is a very real possibility and one that all investors should be prepared for.
Guardian Gold Sydney
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