Gold’s 50-year relationship with inflation

Gold had a stellar year in 2020, with investors around the world buying record amounts via physical gold ETFs and other exchange-traded products, sending the gold price to all-time highs in August. The precious metal recorded a higher annual return than any other major asset class last year.  This was all due to the pandemic and the “safe haven” status often associated with gold, particularly with negative bond yields reducing the opportunity cost of holding an asset that doesn’t pay an income. Gold provided investors with what proved to be a valuable hedge against an uncertain future.

Conditions in 2021 are (thankfully) much different – or at the very least the outlook seems brighter. Widespread uncertainty has been replaced by several factors pointing to a strong economic recovery with fewer concerns on the downside. That said, inflation has emerged as one of the most relevant downside risks facing investors. In the first three months of the year, US CPI rose by 1.7%, its largest increase in a decade.

We recently polled 100 professional investors in the UK¹ and the majority said they expected US CPI to spike above 2.5% in 2021 but to then moderate to a level (2.0-2.5%) that would be comfortable enough for the Fed to not raise rates. Other surveys suggest a similar outlook as the potential for rapid economic expansion is met with supply-side bottlenecks coming out of the pandemic. What is the market pricing in? The 5yr5yr inflation swap shows higher inflation is expected in the medium-term. The consensus, therefore, is for higher inflation of more than 2% in the US. In this article, we consider whether gold can offer investors an inflation hedge.

What history tells us

A simple study of gold’s performance over the last 50 years would tend to support the theory of gold being a hedge when inflation is notably elevated, in this context meaning when it is significantly higher than any target set (implicitly or explicitly) by policymakers. According to a study by the World Gold Council and using data since 1971, gold has returned 15% per annum on average when inflation has been higher than 3%, compared to just over 6% per annum when inflation has been sub-3%.

If, however, we look into the data more closely and consider not only year-on-year changes but also the direction and velocity of movements – in both directions – we can observe that, although gold appears to offer a reasonable hedge against inflation over the long term, its credentials in this aspect are less clear over shorter time periods. That said, the relationship between gold and inflation was notably closer in the 1970s and ‘80s.

We can see a positive correlation between the gold price and inflation in the ‘70s and ‘80s; during this period, which was just after the official end of the “gold standard”, the gold price and US CPI tended to move together in the same direction.

The relationship has become less defined since then. For example, US CPI grew at twice the rate during the tech bubble, but the gold price hardly budged. An 18% jump in the last few months of 1999 was probably due more to gold’s “safe haven” reputation in the run-up to Y2K and the potential of a “millennium bug” than any concerns around higher inflation.

Has the link severed and, if so, what caused it?

Evidence suggests the interaction between the gold price and inflation is now weaker, arguably since the early ‘90s, and it’s important to understand the cause in order to determine whether it is a permanent breakdown. To answer that, we can look at two of the main drivers of the gold price – fear and opportunity costs. Because gold doesn’t pay an income, has no maturity date and carries a sentimental quality, it’s difficult to value using traditional financial models. Gold – probably more than any other asset – is worth what people are willing to pay for it. And, as we found out last year, people are prepared to pay more than $2,000 an ounce when factors combine.

Although the link between gold and inflation is debatable, the link between inflation and interest rates is more consistent and explainable. The Fed’s monetary policy is driven to support maximum employment and price stability. In 2012, the Fed formally announced its explicit 2% inflation target, but committee members confirmed that same target existed implicitly since the mid ‘90s.

Managing policy according to targets introduced a degree of predictability for investors over the future rate of inflation. Investors were less fearful of the pernicious inflation and dramatic swings in interest rates that caused so much volatility in the ‘70s and ‘80s. And, at least in terms of inflation and interest rates, it seems to have worked. Inflation has been maintained around 2%.

The introduction of other inflation-hedging tools

In 1997, the first Treasury Inflation-Protected Securities (TIPS) were launched, which had little demand from investors who now seemed less concerned about inflation. The UK had been issuing inflation-linked Gilts since 1981, with relatively strong demand from pension funds and other institutions needing to hedge longer-term liabilities. UK inflation had been higher than in the US.

While TIPS are designed to provide a hedge against inflation, with principal and coupons adjusted by CPI each year, coupon rates are significantly lower than traditional Treasuries with the same maturity. Considering Treasury yields are currently still less than 2%, and implied future yields are less than 3%, that may be too great a sacrifice for many investors that expect gradual inflation. 

This brings us to opportunity costs. As mentioned earlier, gold does not pay an income, so if investors can get paid any positive income for a “risk free” asset, e.g. Treasuries, then gold seems less attractive. Crucially, the income needs to be adjusted for inflation, i.e. positive real income.

The outlook – what’s the worst that could happen?

The market is pricing in CPI of 2.0-2.5% (with the risk of overshooting) and yields of roughly the same. As such, real yields may remain close to zero – or even negative – in the near to medium term. That doesn’t necessarily mean gold should now look attractive, just not unattractive.

Which brings us back to fear – what’s the risk of inflation spiking considerably higher than what is currently forecast? Many of today’s investors may not remember inflation over 5%. Sharp spikes are rarely forecast; they typically come from external shocks, for instance the oil crises in the ‘70s. Beyond inflation, people are still worried about Covid, including the possible spread of new variants, how the economy recovers as well as social and political unrest, which continue to bubble away in the background.

We have discussed other assets that are a more direct way to hedge inflation but if inflation were to surprise to the upside and overshoot current estimates, gold may shine brighter. The turning point could be if inflation goes from a “comfortable” 2-2.5% to a much more worrying 3%+. That could be when the Fed steps in with rate hikes and doubts come into play. You can still debate whether gold is an inflation hedge, but it can be a useful tool for uncertainty, especially when nobody expects it.