11.10.2021: Gold is poised to suffer its first calendar year loss since 2018 as it hovers around $1,800/ounce. It appears the inflation hedge and store of value has been largely forgotten in a year when the theoretically “transitory” inflation flareup now appears to be longer lasting. But the question is why, when the environment this year has been seemingly favorable for gold? Annual inflation has spiked from 1.4 per cent year-over-year through January to 6.2 per cent as of this morning. Treasury yields, meanwhile, have not moved at a parallel rate, as bond investors believe inflation will spike and then return to its long-term trend. That means real yields – the difference between Treasury rates and inflation – have slid increasingly negative. The Federal Reserve has announced it plan to reduce its bond purchase program by $15 billion per month and is prepared to adjust its pace as necessary. The tapering program was widely telegraphed and has been fully priced into today’s Treasury yield curve.
Real yields have historically been a key driver of gold prices. That’s because gold, an alternative currency with a zero real yield, which is expected to keep pace with inflation over time, becomes incrementally more attractive when Treasury yields trail the inflation rate. The longer real yields are negative, the more attractive gold becomes. Yet this relationship disconnected this year. Gold futures kicked off 2021 above $1,900/oz after peaking at over $2,000 in August 2020. Spot gold is now trading above $1,800/oz, its highest level since September yet about 4 per cent lower for the year.
Some investors blame Bitcoin and other cryptocurrencies for the precious metal’s unexpected pullback. The crypto space has attracted billions this year, doubling the value of its flagship currencies, Bitcoin and Ethereum. While cryptos may be the new shiny objects, we don’t expect them to displace gold as an inflation hedge. The alternative currency sports a volatility seven times that of gold, including four drawdowns in excess of 50 per cent over the last five years. That doesn’t sound like a safe haven store of value.
The total value of the world’s gold is $10.5 trillion, $2 trillion of which is held by investors as bars and coins. That’s equivalent to Bitcoin’s current market capitalization of about $1.6 trillion. Cryptocurrencies collectively weigh in at over $3 trillion. Given the size of the gold market, a 1 or 2 percentage point shift in institutional allocations could be the catalyst to drive prices higher.
While it’s difficult to determine whether gold is cheap or expensive, examining gold miners offers clues. Not surprisingly, the returns of gold and gold miners track closely. According to a recent Barron’s report, gold mining shares are trading at a significant discount to the S&P 500, with a price/earnings ratio of about 13x vs 24x for the broader market. They trade at 1.6x book value vs 4.5x for the S&P and offer dividend yields more than double that of the large cap benchmark. Perhaps that suggests the glittering commodity is relatively cheap.
We expect inflation pressure to persist well into 2023 while the Federal Reserve is loath to tighten too quickly. That means that real rates, one of gold’s key drivers, should provide a tailwind to gold holders.