Thursday, September 10, 2009

Gold and the USD: A warning flag for government bonds?

If the run-up in gold prices and the fall in the USD is driven by or is fuelling inflation fears, thenthe situation for government bonds will become more challenging, as not only are equities continuing to rise amid improving real growth expectations but rising gold prices and the weak USD (and associated with that rising oil prices) threaten to reverse - at least temporarily - a key reason for the bond performance of the last weeks: waning inflation fears.

Trade-weighted USD vs. Gold: Close relationship
Source: Bloomberg

As the chart above shows, gold and the USD (I used the trade-weighted index) have been moving in a close relationship over the past year, barring the armageddon-like environment at the start of the year which drove investors into the safe haven of the USD and gold at the same time. However, the usual relationship is the opposite: a weak USD is going hand-in-hand with rising gold prices. A weak USD can be judged to be inflationary for the US which would help gold but additionally, a weak USD can be a sign of waning confidence in the US economy and its institutions.
Now if we compare the performance of the USD and gold with the development of 10y UST yields, at first sight there exists no meaningful relationship. The first chart shows the last 5 years of 10y UST yields and the USD (inverted).
10y UST and USD: no meaningful relationship over the longer term
Source: Bloomberg

The next chart compares 10y UST and gold over a shorter time frame (the period of the financial crisis) and again I can detect no meaningful relationship.
10y UST and gold: no meaningful relationship during the financial crisis
Source: Bloomberg

However, it gets much more interesting if we use break-even inflation rates instead of nominal yields. Given that 10y TIIs have been suffering ever since the financial crisis started from very high liquidity premia, the incorporated break-even inflation rates have been distorted and I think that 10y inflation swap rates provide a more accurate picture about the development of inflation expectations. The first chart below, therefore, shows 10y inflation swaps vs. the trade-weighted USD. It shows a relatively close co-movement during that time period, however, again at the start of this year clearly an opposite directionality.
10y inflation swap rate vs. USD
Source: Bloomberg

If we compare the swap rate with gold, then the co-movement - while far from perfect - appears closer.
10y US inflation swap rate vs. gold: a relatively close co-movement during the financial crisis
Source: Bloomberg

What I take from these developments is that a) inflation expectations are indeed as is frequently stateed a key driver for gold prices but b) while gold seems to be a good hedge against a systemic financial crisis it is not a good hedge against a deflationary development. For government bonds, though, if the recent performance in gold and the USD is driven by or is causing renewed inflation fears, then this would bode very ill for the near-term outlook. As I have written on several occasions, the reason for the apparent discrepancy between equities (up) and government bond yields (down) over the past weeks can be found in easing inflation pressures as evidenced by a falling commodity price index.
Discrepancy between equities and government bond yields explained by commodity prices
Source: Bloomberg

As I stated previously, I still fail to see how inflation pressures will intensify in the US and Europe (baring the UK) amid huge overcapacity and limited credit creation but admit that the latest price action in gold and USD are raising a warning flag for government bonds as it might suggests that markets' inflation fears are on the rise again which would take away a key support for govies if it carries through into the broader commodity complex.

But was the surge in gold prices really been driven by inflation fears? The usual suspect behind anything that moves these days, the Chinese, have naturally been cited. However, the behaviour of nominal USTs does not fit this picture as the 10y US T-Note futures is trading unchanged from its Friday close. If indeed the Chinese were behind this move (as they lose faith in the USD), then nominal US Treasuries should have suffered more this week, especially given the heavy supply. It rather seems to be that a large gold producer (Barrick Gold) is unloading its gold hedges (i.e. buying back the gold it sold forward). This article refers to research by UBS which states that between July and September 7, Barrick has reduced its fixed price contracts from 5.4moz to 3moz and apparently has reduced outstanding contracts further over the past days to a level closer to 2moz. If this is indeed the prime reason behind gold's recent bull run, then it would rather constitute a temporary increase in demand for paper gold (via the closing of outstanding contracts) offset by a future increase in supply (via the selling of then unhedged physical gold). In turn, I would not regard this explanation as having an inflationary spin.

Overall, the jury is still out on whether inflationary fears are likely to rise once again in the short term which would see government bond yields moving higher. So far, I stick with my assesment from Monday (Rates Strategy: Indecision): government bonds are still undecided about the next move and I still do not yet see enough reasons to change by bullish tactical stance.

1 comment:

  1. Governments always ruin the value of their paper money and a nice simple reason for golds move was posted on Lew Rockwells site

    Title: Gold is Money! By Greg Canavan
    "Gold is rising because the international monetary system, with the US dollar at its core, is in the process of breaking down. Decades of unfettered credit creation by the global banking system, led by the US, is now beginning to implode. This is deflationary, as the private sector begins to reduce its huge debt burden." "The end game is a massive devaluation of the currency.

    Devaluation against what? All other nations are trying to inflate their economies equally by issuing huge quantities of government debt. China is no exception. With the yuan linked to the US dollar, the Peoples Bank of China must print money to maintain the link. This is causing asset bubbles (equity markets) to surface again in China. All fiat currencies are equally as bad.