Despite soaring US yields, dollar risk favors gold

The last time the yield of inflation-protected US Treasuries stood at 2 percent – just before the 2008 World Financial Crisis – gold traded at $800. Today the 10-year inflation-protected yield is back at 2%, yet gold trades at more than twice that price.

For the past fifteen years, gold has traded in a straight line with the yield of Treasury Inflation Protected Securities (TIPS). It still does, but after the Covid crisis and the Ukraine war, it’s a different line.

As the Federal Reserve pushed up US interest rates, gold fell from over $2,000 to about $1,625. That’s still $800 more than the long-term historical relationship would have predicted. Between 2007 and 2020, every 1 percentage point move in the 10-year TIPS yield corresponded to a $300 move in the gold price. But after March 2020, the same move in the TIPS yield shifted the gold price by about $50.

That’s an enormous change, and a worrying one: The inflation insurance that the US government sells bond investors suddenly is a lot less valuable than gold. It’s the difference between buying a voucher for a seat on a lifeboat from the captain of the Titanic, and buying your own life preserver.

Gold and inflation-indexed government bonds both provide insurance against unexpected inflation and dollar depreciation. TIPS are indexed to the Consumer Price Index, and will pay out big if the dollar monetary system goes pear-shaped. Gold is the currency of last resort, the “barbarous relic” (as J M Keynes called it) to which individuals and nations resort when fiat money loses credibility.

Buying insurance from governments that are the cause of inflation loses credibility when the same governments get reckless. The US government’s $6 trillion stimulus gave a massive demand shock to the US economy and provoked the worst inflation since the 1970s.

There are a lot of risks to buying insurance against US government policies from the US government itself.

For one thing, the Consumer Price Index (against which TIPS are indexed) could lag actual inflation – exactly as we saw during the past year. Housing inflation ran at a 20% annual rate until quite recently, while the “shelter” component of CPI rose at just 5% or 6% a year.

Another risk is that the US government might tax away the big payout investors get from TIPS. The explosion of federal debt to 130% of GDP, a level not seen since World War II, portends tax increases in the future.

The risk that governments might change the payout rules of their inflation insurance policies blew up Italy’s market for inflation-protected securities in 2012, during the financial crisis that nearly engulfed Italy, Spain, Portugal and Greece.

Under normal circumstances, economic theory teaches, real yields are supposed to converge among markets with free capital flows. The real yields on inflation-indexed government bonds in the US, Germany, France and Italy traded together before the 2008 financial crisis, and they trade together today. But in 2011 and 2012, Italian real yields jumped to 7% while real yields elsewhere fell to zero.

Once they had read the fine print in their bond contracts, investors found that Italy wasn’t obligated to pay its debt in the Euro, the common currency that it adopted with most of the rest of Europe in 1999. Italy had the option to drop out of the Eurozone, revive its old national currency and pay its debt in devalued local currency. That’s another form of confiscation risk, and it put a big risk premium on Italian inflation-indexed yields for a decade.

But the biggest risk of all came after Russia invaded Ukraine in February 2022. The United States and its allies confiscated about $300 billion, or about half of Russia’s reserves, in retaliation. If Washington can seize Russian assets because it deems Russia in violation of international law, why not Saudi Arabia’s, or Turkey’s, or Uzbekistan’s or the assets of any other country that transgresses what the US likes to call the rules-based international order?

The weaponization of the dollar for geopolitical purposes raises the ultimate confiscation risk.

Not surprisingly, central banks bought more gold than ever before in history – about 400 tonnes worth – in the third quarter of 2022, according to the World Gold Council. About half of those purchases weren’t reported, the council notes. China hasn’t reported its gold reserves since 2016. Saudi Arabia well might be a buyer, along with any country afraid of crossing the United States.

As Berkeley Professor Barry Eichengreen explains in a recent Foreign Affairs essay, the world is slowly shifting away from the dollar – the dominant currency for international transactions – to local currencies ranging from the Chinese RMB to the Russian ruble, the Indian rupee, and others. That probably will increase the demand for gold.

None of the smaller currencies is supported by the deep capital markets that made the dollar (and the pound sterling before it) the reserve currency of choice. Emerging-market central banks that issue more of their currency to finance international transactions will want more reserves as a shock absorber in case of financial stress, and gold will make up a larger portion of their reserve mix.

These factors explain why gold has performed far better than the rise in real yields would predict, and why individual investors should own some gold as insurance against monetary mishaps.