Friday, September 3, 2010

Gold price and bond price - a comment on the efficient market hypothesis

We live in a strange world - the 10 year US Treasury is trading with a 2.63 percent yield.  The market is presuming that there will not be much inflation in those ten years.  However if there is deflation (as per Japan) then the 10 year will wind up being a very good investment (see my blog post on Japanese bond yields from the perspective of a Japanese household).  

At the same time gold is appreciating very sharply - from $950 per oz to $1250 in the past year - and from $800 two years ago or $450 five years ago.  On the face of it the gold price is predicting inflation.

Try as I may - I can't see any reason why both those prices are correct.  I have long held the view that prices are mostly sort-of-rational - and that finding patent contradictions in pricing should be rare - because - if you can find them - there is usually a way to make money from them.  But this looks wrong.  

So either there is a theoretical way in which both these prices can be correct or even my weak version of the efficient market hypothesis is spectacularly wrong.  But finding the way in which both these prices are correct is taxing my ingenuity.  

My first question thus is can anyone tell me why these prices could possibly be consistent?  Is there a rational reason why the bond market is pricing low inflation and the gold market seemingly pricing high inflation?  Does anybody have the ingenious world view in which both these prices are correct?

The second question is more mercenary.  If this really is as irrational as it looks what is the trade?  What is the set of transactions I can place in financial markets which should make me money?  My gut reaction - being a short-seller - is to short both the long bond and gold - but there are some awful tail-risks with that trade.  For instance suppose money becomes suddenly near worthless - a Zimbabwe outcome.  Then the gold price goes to the moon - and I have to return it - so I lose badly.  And the bonds were a wonderful short in that I just made a lot of dollars - but the dollars are suddenly alas also worthless - they don't solve my problem of being short gold.

So - dear readers - thoughts?

 

John 

57 comments:

Anonymous said...

"I have seen many people debate whether gold is a bet on inflation or deflation. As I
see it, it is neither. Gold does well when monetary and fiscal policies are poor and does
poorly when they appear sensible. Gold did very well during the Great Depression when
FDR debased the currency. It did well again in the money printing 1970s, but collapsed in
response to Paul Volcker’s austerity. It ultimately made a bottom around 2001 when the
excitement about our future budget surpluses peaked." David Einhorn

arnaud said...

" This is because gold is the only real hedge against the massive financial excesses that still prevail in the Western world. The really attractive option about gold is that it is a hedge both against an inflationary or a deflationary hangover from these excesses, or indeed an ugly combination of both." Christopher Wood (Greed and Fear from CLSA)
Interestingly, this was written in 2002 ! Hope it helps

Potato said...

John: I can't understand it either. My best guess is it's part of an emotional not-stocks not-RE investment move. I suspect that's not the correct explanation though, because otherwise I'd expect that this should have reached a crescendo months ago.

Unfortunately, I'm just a retail kid, so I'm not much for going short. I looked into potentially using inverse ETFs to do the job, which takes away your long-tail blowup risk (they can still go to zero of course, but not take everything else out with them), but these don't look to be particularly great ways to make money on the short side even if you're ultimately right in your call... too path and timing dependent.

Keep us posted as you work towards solving this mystery!

Anonymous said...

I'm not seeing how a judgment that a binary outcome is reality, while a return to 'the old normal' is very unlikely, would conflict with the efficient market hypothesis.

jb said...

I don't know that Gold is good for inflation protection. Equities have traditionally been better (so long as the companies can pass on the costs).

And, agree with the first two comments - although past comparisons may be misleading because of the presence of the gold standard during those times (which explicitly tied currency with gold, which is not necessarily the case now - atleast, not as explicit)

Perhaps, and this is just speculation: Gold does better when inflation expectations (and monetary policies) are volatile?

I prefer to not look at it as a choice between inflation/deflation (as far as investment decisions go), but instead, it may be profitable to try and trade the volatility of inflation expectations. Also, using the right instruments - inflation will show up more in emerging economies, things we need as opposed to things we want.

jb said...

As far as specific investment strategy goes, my 2 yens:

By shorting gold and bonds you would be shorting the two best asset classes of the last decade. It is a good idea (just on the basis of asset class valuation mean reversion) but timing is a problem, just as timing shorts on the ending of a bull market is problematic.

However, bonds have given much better balanced opportunity for long and short side trades (as compared to Gold). Long 2008, short 2009, long 2010 - the moves are long enough to be able to trend follow.

Gold on the other hand has been up through 2008, 2009 and 2010.

Maybe, long gold and short bonds is a good idea (given current prices). Basically betting for the scenario where there is sufficient doubt over currencies, sovereign risk, loose money, etc but not really a deflationary scenario. Also, performance wise, if you were to be wrong, I think it is better to lose 10% in a deflation outcome than to lose 10% in an inflationary outcome (greater real loss).

Anonymous said...

The Federal Reserve controls the interest rate on federal debt. They dial in the number they want, and then go create money, hand it over to the Treasury, and receive a T-Bill or T-Bond or T-Note back. Lower interest rates are indicative of large amounts of money being created. Some of this money is finding it's way into gold.

Trade silver: Silver is no longer a monetary metal and cannot be revived as such due to its demands in industrial applications. A massive above ground stock of silver was built up for ~4000 years of human history. That entire stock has almost been depleted over the past 50 years as silver has been used up in all sorts of consumer gadgets. When that source of scrap silver is finally depleted, silver prices will explode. Silver will be very volatile until then. So a volatilty trade (option straddles) on silver will do well.

IF said...

First a guess. Can we assign gold a long duration, just like non-dividend paying stock? Then it would be clear why lowering interest rates not only supports long bonds but any asset that stores well.

Second, how about long bond owners believe in a survivable deflationary environment while gold bugs (physical gold!) believe in a total collapse? Problem with this of course is that one has to wait until way after the collapse for gold to regain value again.

Economic Darwinism said...

Whenever I see an article like this relating gold and inflation, I am reminded of David Einhorn's comment where he said gold is not a hedge against inflation. Rather, it is a hedge against bad fiscal and monetary policy. It is hard to argue with that.

Andy said...

Isn't the answer rather obvious? Everyone is getting out of equities because we are in for a long slog with lots of unemployment and little growth. Why would equities prosper? And where are these people going?

Well, they are not all of one mind. Half think we're in for inflation, the other half deflation. So, the former go to gold and the latter go the treasuries, bidding them both up.

Pete DZ said...

Fat tails - the world of no middle. We are either likely to experience deflation or, if various QE policies backfire, potentially higher than expected inflation. So depending on which you believe, you buy either gold or bonds. Plus, as a few people have already mentioned, I'm not sure you'd lose money on gold in deflationary environment.

MBJ said...

John:
Thanks for all the great work you do on your blog - I look forward to reading all your stuff. On the high gold price, one explanation is offered by an old Larry Summers and Barsky paper (JPE, 1988)which argues that since gold is a durable asset its price is inversely related to the REAL longterm interest rate. At the moment holding gold is virtually costless in comparison to T-bills since real rates are negative. Even 5-year real yields implied by TIPS are only 0.13%. I would not go short until the Fed starts raising short rates and these real rates start to rise. Of course if we get serious deflation - worse than Japan's then real rates will also rise with rates still at zero but I view this a v v low probability.

John Barrdear said...

Broad point: I have no freakin' clue.

Idea #1) Yes, yes, your whole post was predicated on some weak version of the EMH. However ... Treasuries, despite what the arch-conservatives are saying, are unlikely to be in a bubble (see idea #4 below). It might (and only might!) even be impossible for them to be in a bubble. On the other hand, gold can experience a bubble (to the extent that you concede that bubbles can exist at all). Just because it can doesn't mean that it currently is in one, but if it is and treasuries are not, that would partially resolve your dilemma.

Idea #2) Gold, as a commodity, is a affected by global phenomena, whereas US treasuries, while obviously still influenced by global pressures, are more sensitive to the US economy than is gold. This statement will become more true over time as the US economy shrinks as a share of global GDP. Therefore, perhaps you should deduce that markets are predicting low inflation or deflation for America, but quite high inflation for the world as a whole.

Idea #3) Gold, as a commodity, partially co-moves with other commodities, many of which are seeing price increases because of real, observable events in their markets (Chinese construction, Russian drought, etc). Perhaps it is being dragged up by those (this augments idea #2).

Idea #4) In the broad market for USD-denominated investment-grade bonds, there has, I believe, been a net contraction in supply despite the surge in US government borrowing. This is the private-sector balance-sheet correction. One might argue, from something of a monetarist point of view, that (disin|de)flation is occurring in the US precisely because the US government is not expanding its borrowing fast enough to replace the private-sector contraction.

Idea #5) Another non-EMH idea, I'm afraid: Both the USD and gold enjoy safe-haven status. An increase in generalised fear (Knightian uncertainty, unknown unknowns, etc) will shift out the demand for both at all price levels. To the extent that such a dynamic exists, I suspect that it ebbs away only slowly and, while elevated, is susceptible to rapid increases in response to events that would, in normal times, not affect people so much.

Uldis said...

In deflation banks go bust, gold does not.

Anonymous said...

Just a train of thought: Think of a global pool of capital that is looking to be deployed. Key criteria could be a) liquidity, b) "principal" protection in a relative way ... And any price increase in some asset classes feed on itself

SPV

But What do I Know? said...

One way of viewing this situation would be to consider both gold and Treasuries as forms of "cash." (I know this sounds absurd, but hear me out.) Gold is "cash" which is held in a non-government currency, and is presently favored because of the large amounts of fiat currency which have been and are being created in excess of useful goods, and also because of the low short-term interest rates in those currencies. LT Treasuries are favored because of the demand for cash-like instruments as collateral--collateral which is required because of the enormous number of derivative positions outstanding. IMHO, no one is buying the 10-year because they plan on holding it to maturity--it's just that if they have to provide collateral it might as well be with something that pays some interest. My impression is that there is no haircut on Treasuries, even longer-term ones, but you would know much better than I would if this is true.

So both gold and Treasuries fill a demand for "cash," just in a different way.

Kid Dynamite said...

A few have touched on this already, but think of it this way: what if the Fed said they'd rename themselves The House of Quantitative Easing, and simply continue to print money to buy Treasuries ad infinitum?

Tsy yields would remain low, and gold prices would continue to climb, right? Don't get hung up on "inflation" as the only factor. Like someone wrote above, gold is a hedge against bad monetary policy.

Epicurious said...

Interesting question, I've looked into this on more than one occasion and the best article I could find that I could understand was this one:

http://globaleconomicanalysis.blogspot.com/2007/02/is-gold-inflation-hedge.html

Which is that gold is generally not a very good inflation hedge, is a better deflation hedge AND a good "crisis" hedge. Let me know if you reach any better conclusions!

I must admitt that I am not a huge fan of gold. I understand that due to its history of being used as currency, there is an innate "stickiness" to people comparing it against our fiat economy, but frankly gold in and of itself is not economically useful.

Anonymous said...

None of the comments above mention that Bernanke is printing to buy the paper. This suppresses yields. The Elf Geithner and his overlords cannot afford a spike in rates so they have them "managed" to the n-th degree. Gold is for the people who think that this cannot go on so long without negative effects.

Anonymous said...

Peak gold.

Humble Student of the Markets said...

I have been puzzling over this condition as well and concluded that the market is concerned about tail risk. (Also consider the apparent popularity of "black swan" funds and hedging techniques.)

This just tells me that tail risk is likely overpriced.

dk said...

Isnt the key factor about both that gold over time is very good at maintaining its vaue and that govt bonds are in theory,the safest way to ensure ones capital is preserved[over the short term at any rate.
ie capital safety is the unifying feature.

Jake said...

put everything in supply / demand terms... there is more demand for high quality bonds than supply (though supply has jumped) and there is more demand than supply for gold (ETFs are now as large a holder as the large central banks AND central banks are adding), while supply remains constrained by the amount that can be dug out of the ground each year

Anonymous said...

The difficulty of money laundering is increasing due to technological advances.

Anonymous said...

Gold is a hedge against negative real returns in all other asset classes. Look it up.

Borderline

Robert in Chicago said...

Almost every day for about a year, David Rosenberg has been beating the drum to own _both_ gold and T-bonds. He is a deflationista who sees that gold has done well in deflationary periods.

But I still think you're right. If gold does well in deflationary periods because the government will ultimately print enough money to beat the deflation -- which I believe is correct -- why doesn't the bond market see that also? (Or more specifically why does the gold market see it far sooner than the bond market?) I agree with one of your commenters that the bond buyers and the gold buyers probably have different opinions, and enough of them don't trade the other asset such that the divergence can sustain. Also, some of them have different objectives besides just betting on inflation or deflation.

Our fund's answer is to say "deflation now, then inflation, the market opinion will catch up." Long gold and short T-bonds are two of our largest positions. We are not sure deflation won't come and won't last quite a while, but we are sure that deflation risk is currently "overpriced."

Robert in Chicago said...

P.S. Charlie reminds me that gold is a much more attractive currency, relatively, when cash is paying 0%, than it is when cash is paying 5% or more.

jaguaracer said...

Someone said it: its all about the REAL interest rate. I just plotted real 10y rates inversely against front gold futures contract.

**Practically identical** match over the past 5 years except for a period around Lehman in '08 when TIPS went all out of whack due to repo/liquidity/loss of sanity issues I think.

I have to find a way of uploading it.

The real cost (pardon the pun) of holding gold is the opportunity cost of holding another inflation-indexed security.

Anonymous said...

If the opportunity cost of gold includes the competition of nominal interest rates, then the deflationary aspect of the bond "bubble" removes a major obstacle to holding gold.

The removal of this barrier may be part of the gold rally.

Carey said...

Its easy John, there is no penalty to own gold when the real short term interest rate is 0.

Jason Ruspini said...

The answer is that real rates of return describe the price of gold better than inflation alone. I am shocked that this point is still not more well-known. When CNBC anchors finally catch-on, that will be my tell that the gold run is over.

http://seekingalpha.com/article/185754-the-truth-about-gold-and-inflation

Long gold and long high-dividend stocks still seems like the way to go, even after this past week.

babar ganesh said...

it's EMH. gold is up because people have correctly anticipated its rise.

Anonymous said...

1) Gold is a very small market with a thin float. A few people buying into it causes the price to rise... and then it becomes a self fulfilling phenomenon -- a classic example of reflexivity.

As gold rises, people becomes more concerned about inflation/bad monetary policy, more people pile into gold...

There doesn't even have to be a genuine reason for gold to go up. People seem to invent reasons that justifies the rise of gold rather than the other way around. It's a ridiculous situation.


I personally think gold is massively overvalued in the long run. If you can buy puts on it for cheap... That would be interesting.

Also, there are a lot of unhedged gold companies, and some are shelling out a lot of $$ for acquisitions at astronomical valuations.

Admin said...

I may be wrong, but it seems to me the arguments that one large group of people think one thing (and go gold) which another largr group think another (and go bonds) is incorrect because it would require the nature and character of the market to be other than how it is.

What I mean by this is that with a large number of people - e.g. the market - there are a wide range of views which through the market express themselves as a probability distribution of behaviour, with a central peak at the group consensus.

To see *two* central peaks - e.g. one for gold, one for bonds - over such a large number of actors - is in my view practically impossible. The market does not end up in such states.

Accordingly, I hold the view that what we see *is the consensus opinion*. That we cannot explain what we see by the device of "one group thinks A, one group thinks B".

We must find a solution where a single group thinks something which leads to both outcomes.

Peter said...

I think you are thinking about it the wrong way...gold can simultaneously be a hedge against inflation AND deflation, so it is possible that the long bond and gold are actually saying the same thing.

Why? If deflation becomes a reality, then central banks will be forced to act. They will never act with further easing through quantitative easing before its a reality...the stakes are too high. So the bond market is betting on deflation + quantitative easing which will keep yields depressed. If this causes inflation in the future (this is a big IF as the money multiplier clearly still isn't working) then the bond market will deal with it then.

The gold market on the other hand is also betting on deflation because (through QE) it's the only plausible way mass-debasement can occur to justify the current high price of gold.

So, in summary, the bond market is trying to make cap gains from the pre-infaltionary effects of QE, and gold market is setting itself up for the post-inflationary effects of QE. Slightly different, but the markets are essentially betting on the same thing.

Neil said...

Time frames: Bond buyers see short term deflation and expect to be able to get about before this turns. Gold buyers see long term inflation and are early.

Monetary Disorder: (As most of the other comments point out) Gold is a bet on monetary disorder. Bonds a bet on deflation.

Technical: Bond buyers are not purchasing for yield but for the guaranteed return of capital. Bond purchases are therefore not indicating deflation but simply reflect the "safety" of US bonds. Buyers are willing to sacrifice some capital in exchange for certainty that they'll get the rest back. (buyers of capital protected products make this {bad} decision regularly).

It seems that you could make money on an of these outcomes through a long straddle on the long term treasury bond. You only lose if the "muddle through" continues.

Anonymous said...

Your assumption is incorrect that people buying either treasuries or gold is a reflection of their views on inflation.

Both are fear hedges that the US economy is going to tank, and people are picking their poison, either US treasuries, or gold. They aren't thinking 3 or 6 months ahead, they want to ensure that their money is safe in the very short term.

As to what to invest in, the CEO of Think or Swim, Tom Sosnoff, very recently revealed that he is extremely short long bonds right now. He said he is usually very early, and willing to take a lot of heat for this trade, but he is certain that interest rates will move back up from it's fear/momentum-induced highs and will crash.

Hubert said...

MANY GOOD COMMENTS ALREADY. Let me add this:
1) Gov Bonds are no longer a real fair market. Maybe never were but now defenitely no longer as Governments press money into financial markets by buying them up. I do not care if they buy Treasuries or Fannie MBS, it is all duration leaving the market. What is the EMH for a political motivated buyer with endless buying power ? That does not automatically mean that bonds are a catastrophy to happen but they are a bet on the system staying intact without too much inflation. I would not give that too much probability.
2) If you are a broke TBTF with a telefon call away from billions from the CB windows, you just simply make the call, take the money and buy some state protected FI asset with it. You collect a few hundred basis points spread, pay bonuses and maybe even fill the holes in your balance sheet. If rates should rise you will be bankrupt but so will be nearly all others and as you already were bankrupt before: so what ?
3) Gold. I have trouble keeping the numbers on moving targets. But all Gold ever found at current prices would be less than 4% or so of all monetary "reserves" created in the last decades. So if you doubt the system, but you do not know when it is going to break, you rationally switch 10-50% of your "money" into gold preferedly physical and preferedly in different locations. Then when a new game begins some of it might find its way back to you and you do not have to start at "Go" again. So gold is systemic insurance with the caveat of all insurance: it might be hard to collect in case.

Hubert said...

4) While the gold bull was in its accumulation phase (2001-200X) big amounts of reserves switched from Dollar to Euro. It became apparent now that the Euro is no long term survivor and there is no legal clarity what you might receive at its dissolution - so it is no safe harbour for Big Money. Big Money is now looking for alternatives in FIAT but candidates (Canada, Singapore, Norway) are all too small to take on these amounts.
5) Even if the system somehow holds together, its fragility might become more and more apparent to laypeople. They also may go for gold and you sell it to them and try your luck with different assets which may present themselves to you in time. This kind of bet might can be made on the CME with very small contangos for now. It is a paper claim though and you collect in FIAT.

Anonymous said...

There have been many excellent observations.

I would add:

1) echoing comment above, flight for safety if a flight for cash and cash-like instruments. Gold and treasuries are both great collateral.

2) if you value a gold miner with a standard DCF equity valuation, you need to put a positive fudge-factor in to make long term gold company and fund valuations work. People irrationally love gold companies for some reason.

3) Gold is not correlated. Build big correation matrices with other stocks and gol miners, and apply clustering - you'll find gold miners as an outlier cluster. The "all the correlations go to 1 in fear scenarios" truism doesn't work for gold stocks. If umpteen CAPM enthusiasts all make the same observation and behave "rationally", gold goes up in price.

David Pearson said...

John,

An important question. The performance of gold and bonds is logically consistent.

First, let's get rid of all that "gold is a safe haven", or "gold does well in deflation" talk. Gold has a few simple attributes: it is of infinite duration and has limited supply. This makes it an inflation hedge, pure and simple. The thing people don't understand is that gold hedges all future expected inflation in a currency. Because of its duration, it may not respond in a "logical" manner to near term inflation signals.

Which brings us to gold and bonds. The more deflation risk we face, the more the Fed may turn to unconventional measures to stem it. These unconventional measures will be taken in the belief that the output gap controls inflation. Therefore, inflation will not be possible until we have real growth, and when we have real growth, the Fed can tighten to stop inflation.

But what if the above view is wrong? What if velocity can spike even under a severe output gap? Then the more the Fed resorts to drastic measures in the mistake belief that they will not cause inflation, the more risk of higher inflation in the future.

What "squares the circle" of bonds and gold is an absence of long term real growth expectations. Long term real growth is the enemy of bonds and gold, and the friend of stocks. The performance of all three asset classes for the past ten years is consistent with the view that real growth will be scarce, and that governments are already producing fatter and fatter inflation and deflation tails. Think of it this way: what if the Fed had not been so easy in 2004: the shadow banking system would have remained much smaller, and the risk of deflation now would be much lower. It was the reaction to low growth expectations on the part of the Fed that brought about deflation risk, and is now creating more inflation risk.

David Pearson said...

BTW, I am not arguing that high inflation is a "sure bet". The performance of gold and bonds reflects the fact that, given the probability distribution of expected inflation/deflation, and the associated expected returns, a portfolio with more of both gold and bonds is closer to optimal the fatter the inflation and deflation tails.

GoldBug said...

Believe the inflation argument may have more merit.

Look no further than the bidding war between Eldorado and Goldcorp over Aussie miner Andean Resources late last week.

James B. Shearer said...

I don't see the contradiction with the EMH. This could be like betting on two horses in the same race. Only one can win but both can be good bets. Which isn't to say both bonds and gold are correctly priced but logically it is possible even if only one can do well.

Charles Butler said...

Probably a combination of population and disposable income growth since 1980 as well as access to technology and 'information' (to coin a phrase). If you throw the match of a big time financial crisis onto that mix, 1200 nominal looks pretty disappointing.

Anonymous said...

Here's a thought: to see what the markets are expecting you should widen your view to take in commodities in general (not just gold) and bonds in general (not just the long U.S. Treasury bond).

Another thought (already expressed by several commenters): in the last couple of years there has been a "flight to quality"--in other words, a greatly increased aversion to (perceived) risk. Both gold and U.S. Treasury bonds are perceived as relatively safe.

I agree with Admin in rejecting the bifurcation theory (that half of investors--the gold-lovers--are anticipating inflation and the other half--the U.S. long-bond-lovers-- expect deflation).

TheDrugsDon'tWork said...

John, if you are looking for a trade I guess the question is who are you trading against?

1) If treasuries and gold are being brought by the Chinese government to keep their currency depressed then you should enter the trade when Chinese’s businesses are going bankrupt (assuming the Renimbi is still suppressed when this happen). At the present levels Chinese manufactures are JUST profitable so stay away - this madness can carry on for some time.

2) If the treasuries are being brought by deflationists and the gold is being brought by the inflationist’s (and neither believes their thesis enough to enter each other’s market and take the counter bet)? Then may be you should agree with both camps and look for a stagflation trade instead.

3) May be treasuries are being brought by European central banks following the lead of Portugal (who now have to post collateral as part of their central bank’s operations). If other central banks don’t follow suit then their countries banks are at a liquidity disadvantage. In this world treasuries are now no longer an investment alone but also a commodity required by central banks to fund their open market operations. Buy gold and short treasuries at the point when one last major European bank does not post collateral. (Probably Germany or France)

4) Treasuries and gold being brought by hedge funds: Why bet against hedge funds find the most stupid people in the market and bet against them instead. Better still follow the herd.

5) Pension funds matching their assets to their liabilities – I know it doesn’t explain gold. Enter counter-trade based on demographics. Complicated to calculate.

6) Banks buying treasuries as they are getting short term money from depositors costing 0.5% and can only invest against assets that have a Risk Weighted return of zero percent liabilities – again I know it doesn’t explain gold. You will know better than most when to enter that trade.

Please post any information on who the buyers are.

Finally remember there is less triple A out there now that the securitization market has gone. Can Germany really generate enough triple A to feed the market? Will other triple A’s emerge to fill the void?

Abhishek said...

Dude, its quite simple. People want to preserve capital, they are afraid of the stock, so they are investing in

A.) Bonds - Capital Preservation
B.) Gold - Hedge against downturn, devaluation of currency.

Bond investors are considering a 1-2 year horizon, so they can reposition on where the market is headed. They are the common folks

The second category, influenced by bitter past outcomes, or by doom-sayers, are the people investing in
Gold.

Economics is not a definitive science and we can have new situations.

t said...

For me, both are a risk aversion trade. Framing their performance in terms of inflation/deflation expectations isn't relevant.

Michael K said...

Gold - agree with Einhorn. So buy it now, and sell it when monetary and fiscal policies start to turn more normal i.e. a Volcker steps in.

The Gold trade - join in the bull market and go long (you can buy some cheap put options if are not fully confident on the trade). The turning point will be near impossible to pick accurately. Sell on major trend break or on a parabolic move (maybe have options to catch a parabolic move also). When it comes to play the short side this could be an even better trade (dependent on the excesses of the bull market). Buy put options.

Bonds – manipulated by QE therefore a more short-term orientated market relative to the Gold market – so easier to trade from both long and short sides.

The Bond trade - Range trade it now. Long (maybe using options) after a decent rally on positive economic news. Sell (maybe using options) when the fed step in on poor econ news (like now – look to build shorts over the next six months). This deflation battle could go on for years - who knows?? When the break out occurs (on the short side) go short bonds and ride it like the gold bull market – selling when a ‘Volker’ steps in. Can also play this ‘breakout’ by buying long term high interest hedges – but I would keep a very long timeframe (10-20 years+!!!!) and be very careful how much you pay.

The end game. Japan have been doing this ‘debt deflation’ dance for much, much longer. If you believe Kyle Bass the end game for Japan (bond/currency blow-up) is nigh. Maybe this is the trigger for the peaking of the US bond bubble. Scenario - Japan can no-longer internally fund govt debt, bond yields go up and currency sold down (both relative moves dependent on the amount of QE they use) and the Japanese Government are sellers of US Govt bonds or at least no longer able to invest in new issues of US government bonds reserves. The Fed responds to Japans/World economic woes with a massive QE - sending bond yields to 1%.

China could also blow up (albeit a different way) and have the same (maybe even bigger) effect.

Anonymous said...

I've spent the last two years reading books/articles by Bernanke/other central bankers/policy makers looking at the Depression/Japan/etc. to try to predict how this will end. I bought gold when the G20 announced globally coordinated fiscal stimulus and the central banks similarly a coordinated QE program. More recently, after reading Richard Koo's excellent book and seeing the tide turn against more fiscal stimulus and government debt, I find myself firmly in the no growth/deflation camp for the next 5-10 years and thus bought long term/perpetual fixed income. I sold some gold but cannot bring myself to liquidate the position which may seem illogical against my assumptions. However, I think deflation will win in the short term thereby encouraging ever looser and more innovative monetary policy and potentially more fiscal stimulus which could ultimately cause higher inflation in the long term. Therefore, I'm betting on both gold and fixed income based on different outcomes at different times.


There seems to be the
assumption that one buys either gold or bonds exclusively when in fact some may be buying both.

Rich said...

Regrettably, I don't have the answer, but do have thoughts on what could cause a change.

Gold is being bought by investors, but the retail jewelry firms in the US are doing rather less well due to reduced demand. When the fear is gone, to whom do the owners sell?

Bonds are being bought by banks, and will fall when there is a pickup in commercial loan demand. Banks will sell Treasuries to extend more profitable commercial loans.

They are correlated bets in the present conditions -fear- and will both unwind with a resumption of normalcy. But I can't help on timing.

Anonymous said...

If you think of gold only as an inflation hedge, it makes no sense. But gold is not only an inflation hedge. (In fact, if you look at history, it's really a mediocre inflation hedge at that.)

Gold prices are primarily determined by one factor: real interest rates. When real interest rates are low, the price of gold goes up. When they're high, it falls. During inflation, real interest rates may be high or low. Pre-Volcker real rates were extremely low, and gold soared. Once Volcker started raising rates aggressively, real rates rose and gold plummeted. Likewise, you can often have low real rates during deflation (like now), but not necessarily always. If nominal rates rose significantly I'd expect increasing deflation but declining gold prices. But if deflation worsens but rates fall as well (or for S/T rates stay at 0), there's no reason why gold can't do well in that scenario.

Why does this relationship occur? Anybody's guess, but it makes sense if you think of gold as a currency... or rather, not just a currency, but THE currency, the "real" money. (No, I'm not a gold bug... stay with me.) In "normal" times when real rates are moderately high, it makes perfect sense to hold money in fiat currency rather than gold, because you can earn yield on the fiat or make profitable investments, whereas the gold just sits there. But when real rates are low you're not earning much by being in fiat, so it makes sense to convert the "value" into gold to "store" it. (This makes even more sense when you consider that periods with low real rates are often periods of concern about the soundness of fiat currencies.)

Anecdotally, if you look at the price action of gold (at least over the past few years), it's clear that it behaves like a commodity (and thus an inflation hedge) but not JUST a commodity. Gold performed well in the 2009 rally because it traded like a commodity during the "dollar down, everything else up" reflation. But counterintuitively, gold also performed very well during the initial flare-up of the Euro crisis, when it was clearly trading as a safety currency (the rush into gold was topped only by the rush into CHF).

If you think of gold as either "this" or "that" then it makes no sense. Gold as an asset really is unique and cannot be easily fit into simple categories like "inflation hedge" or "deflation hedge".

Craig Stanley said...

The prime driver of the price of gold denominated in US dollars is U.S real interest rates. The last bull market in gold (late 1970s) corresponds to when 10-year real rates were negative on both an ex ante and ex post basis. The current bull market in gold started in 2001 when the 3-month real yield went negative; the 10 year real yield is still slightly positive but if it goes negative, the gold price could really run. Barsky and Summers stated this reasoning in their 1999 paper: “Gold is a highly durable asset, and thus…it is the demand for the existing stock, as opposed to the new flow, that must be modeled. The willingness to hold the stock of gold depends on the rate of return available on alternative assets.”

John Barrdear said...

John, I'm not sure if you read comments on posts this old, but if you do, you may wish to wander over to Econbrowser to see Prof. Hamilton's latest thoughts on the matter: http://www.econbrowser.com/archives/2010/10/the_market_move.html

Stuart said...

Gold rises as confidence in the government/fed erodes. The reserve currency allows the fed to keep interest rates low until either there is a solid recovery, which will cause rates to rise and bonds to fall (and gold to fall as confidence rises) or a waterfall collapse of confidence event (which will cause gold to soar). So the trade is a spread trade which won't pay off until the waterfall event. People underestimate the likelihood of adverse events so it is proof that the market is not efficient. The bonds are too high and the gold is too low if we all had perfect foresight.

Anonymous said...

Aren't both these trades basically people arguing that the USD is going to lose value?

So if you take a position on the USD wouldn't that be the contra position you can profit from?

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