Newbie precious metal investors suffered a shock this past week. Both gold and silver prices have surged in recent weeks with gold taking out record highs (in dollar terms) and silver breaching levels last seen several years ago. In the space of a few days though gold fell $200 per oz and silver plunged $5 per oz. The catalyst for the drop pinned on an unexpected spike in US bond yields.
It’s worth taking a step back to see how we got to where we are today and what that means for the prospects for gold going forward. For that its worth considering the unique circumstance we find ourselves in, particularly the zero interest rate bound.
2020 marks the first time in history that the yield on both short and long-term US bond yields is near zero. Even in the after the quantitative easing that took place after 2008-09 the yield on long duration bonds was about 3%, versus zero for the short-term. All other things being equal, lower bond yields increase the attractiveness of holding gold. It isn’t just a feature of the US – roughly 80% of global government debt is yielding less than 1%.
The zero interest rate creates some particularly unusual characteristics that influence investor demand for gold. As Bridgewater Associates highlight, inflation and real rates (nominal minus inflation) tend to rise and fall together when rates are sufficiently above zero, but when they are at zero the relationship tends to invert complicating the task of policymakers:
Zero nominal yields also create a unique linkage between real yields and inflation. Because there is an arbitrage between the breakeven inflation rate* and actual inflation, a deflationary downturn that pushes breakeven inflation down is extra risky because the combination pushes real yields up as the economy contracts (because the real yield plus breakeven inflation must equal the nominal yield, and the nominal yield is relatively stable), i.e., you have a higher discount rate on cash flows as cash flows fall. On the other hand, if reflation is successful, central banks will likely delay the rise in nominal yields relative to inflation, forcing real yields to fall. And there is no lower limit to either real yields or breakeven inflation. As a result, a successful reflation can drive real yields much lower even if they start at low levels, and policy failure (i.e., deflation) will drive them higher.
As shown below, Japan has experienced these dynamics since the ’90s. Before rates reached the zero lower bound (marked below with a gray vertical line), inflation and short rates fell and rose together, reflecting the central bank’s responsiveness to conditions. But after rates reached zero, the relationship inverted. Falling inflation, when rates are already at zero, forces real yields higher, producing a tightening as conditions are deteriorating.
* The breakeven inflation rate is the difference between the yield of a nominal bond and an inflation-linked bond of the same maturity.
I’m old enough to remember when central banks actually increased interest rates to head off an increase in inflation. Many will suggest that this time is no different, and that as soon as activity picks up post-COVID and inflationary pressures appear then interest rates will gradually start to pick up.
Given the outsized impact that even tiny amounts of tightening have on the economy and financial systems, every central bank has made it clear that they will wait for substantially higher inflation to be in place for an extended period before considering tightening.
The historical precedent may not in fact be the 1970’s, the most recent period of high inflation. Instead we may have to look back to the 1940’s for guidance. The monetised fiscal expansion that took place in the US after WWII has a number of similarities to where the US and other major economies are today – COVID being perhaps the last of many straws that breaks the back of debt buildup. As the chart below shows, inflation was allowed to rise sharply higher (eroding the real value of post-war debts), and because inflation was higher than nominal bond yields the real yield was negative to the tune of roughly 20% by the end of the 40’s.
In environments like the 1940’s gold and other inflation-protected assets tend to perform well. Gold as an asset doesn’t pay a yield. It’s has zero dividend. But in order to benefit it only has to be better than the alternative, and if the yield on government bonds is zero or negative then it stands to benefit as bond holders move their funds to gold.
The analysis above shows that even if nominal yields rise, inflation is likely to be allowed to increase by an even greater amount. Central banks and indebted governments worldwide really have no other option.
A couple days after the jump in bond yields data coming out of the US showed core inflation (excluding food and energy) rose by 0.6% in July. That might not sound much but its the biggest such increases for almost 30 years.