Is gold a haven, or a risk asset? This question rekindles my memory of an old Saturday Night Live sketch in which a husband (Dan Ackroyd) and wife (Gilda Radner) argue over whether new aerosol product “Shimmer” is a floor wax, or a dessert topping. Chevy Chase, playing the late-night infomercial salesman, pops into the scene declaring “It’s both!” and proceeds to demonstrate its dual uses. Gold has been considered a store of value since the time of King Agamemnon (Helen of Troy’s brother-in-law). It is an alternative currency that provides no income. Gold has become an attractive currency substitute ever since the Fed in effect slashed overnight rates to zero. Gold’s recent runup since early March has exceeded what dollar weakness would imply, suggesting investors are stashing away gold for additional reasons.
Perhaps investors are clamoring to own the precious metal for diversification purposes, because the diversification benefits of other, traditional asset classes have eroded over the years. Diversification, a concept pioneered in the 1960s by University of Chicago economist Harry Markowitz, has lost its luster in an era of point-and-click ETF rotation. Professors Allen Michel, Jacob Oded and Israel Shaked, of Boston University School of Management and Tel Aviv University, demonstrated that correlation among seemingly disparate asset classes tends to converge toward one (perfect correlation) in periods of market stress, when US equities suffer their worst decile of historical market performance. The Russell 2000 Index of small cap stocks, for example, tended to correlate with the overall market in both upside extremes (Decile 1) and downside extremes (Decile 10). Rising correlations undermine diversification, especially in extremely negative market conditions, failing investors just when it’s needed most. Michel, Oded and Shaked’s work shows a similar pattern among a variety of asset classes.
In an environment of unprecedently low rates, investors are reassessing the bond market’s ability to have their backs during market turbulence. The Federal Reserve, thanks to record bond buying, is now the largest owner of Treasury securities, possessing 20-30 per cent of Treasury notes and nearly 40 per cent of Treasury bonds, according the The Economist. Having such a dominant, price insensitive buyer in the market has pushed bond yields below fair value, potentially stripping their ability to hedge equity risk in future periods of uncertainty. Investors are wondering if gold could fill the void left by Treasuries in portfolio construction and risk mitigation.
The 10-year Treasury note has done a good job historically, and recently, hedging the US equity market in periods of high volatility often associated with extreme selloffs. Going back daily to 2000, we plotted its correlation to the S&P 500 against market volatility as measured by the CBOE Market Volatility Index (VIX). VIX levels above 40 are considered extreme by historical standards. There were two readings above 80: at the height of the financial crisis (blue dot) and at the height of the COVID selloff (gold dot). In both cases, the correlation between the 10-year Treasury note and the S&P 500 were nearly -1, suggesting that the benchmark Treasury note did a good job hedging extreme equity market selling. Moreover, two-thirds of the observed correlations between the 10-year Treasury price and the S&P 500 were negative when the VIX exceeded 40.
The past is not prologue. The 10-year Treasury currently yields a historically low 0.52 per cent, leaving little room to serve as a hedge. We estimate the 10-year Treasury note has another 5.4 per cent upside opportunity left in the event its yield drops to zero over the next 12 months. On the other hand, with such a slim yield cushion, it would only take a rate rise of 8bps over the next year to push the benchmark Treasury return negative. This suggests that high-quality bonds may not offer the equity hedge that they have in the past.
Can gold fill the void left by Treasuries as a store of value and an equity risk hedge? We conclude gold may not be an equity market hedge, but it could be a useful hedge against the bond market and the banking system. Unlike its financial market counterparts, gold has no offsetting liability, so the possibility of default is eliminated. A global reserve currency in a fiat system creates tremendous incentive to take on too much debt. In an environment in which government revenue fails to cover spending, borrowing from abroad and money printing can cover the shortfall. Gold’s recent ascent, which began in 2016, corresponded to the accumulation of $16 trillion of bonds globally sporting a negative yield, which was an outgrowth of central bank intervention.
Gold has been a useful alternative currency because the dollar has no other viable challengers in the developed world. The problem is, recent activity suggests that dollar weakness only explains a portion of gold’s rise. The dollar’s recent pullback implies spot gold should be trading at $1,647/oz, more than $300 below the precious metal’s closing price, based on a March 12 starting date.
This suggests, if gold’s current value is correct, investors are not simply deploying the yellow metal as a currency substitute; perhaps they’re also holding it as a hedge against equity volatility. Gold’s hedging properties deserve closer inspection. Investors’ desire to hedge market risk taking is understandable. Risk markets have enjoyed unrelenting success in the face of daunting economic challenges. The decline our economy suffered last quarter was the deepest on record, forcing tens of millions of Americans out of work. Looking out over the next couple of quarters, forecasters are trading in their “Vs” for “Ws” or, what Cresset is suggesting, a square root sign, which means we are facing a challenging environment for risk taking. History suggests, however, that gold, while a good diversifier, has not proven itself as an equity market hedge. Our research shows that the correlation between the S&P 500 and gold appears to be independent of volatility levels. We isolated periods of extreme volatility, when the VIX registered levels of 40 or higher. While there may be a slight positive skew, correlation as a function of volatility appears to be random, meaning that gold is a gooddiversifier, but it’s not a good hedge.
Bottom Line: So, back to our original question: is gold a haven, or a risk asset? Yes to the former; maybe, to the latter. Gold has a long history as a store of value; it is an alternative currency offering no yield. It has become increasingly attractive as a dollar substitute as nominal rates approach zero and real rates approach negative territory. Because the precious metal is an asset without an offsetting liability, it could potentially serve as a credit market hedge. Its ability to hedge equity market volatility is spurious, however. History has shown that the correlation between gold and the S&P 500 has been independent of market volatility, making it a valuable diversifier but not a useful bear market hedge. Because the asset offers neither yield nor expected return, it’s impossible to determine what is priced into its current level.