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Gold's uses

Gold does not protect investors from inflation. But it does from many other, more likely, threats.
July 7, 2020

Gold does not protect us from inflation, but it does from lots of other nasty risks. This is the lesson of the fact that its price has recently approached a record high.

This has happened while consumer price inflation in the west has fallen – in the US, to a five-year low and in the UK and eurozone to a four-year low. What’s more, inflation expectations have also fallen. Although the US’s five-year breakeven inflation rate has risen from its crisis low-point, it is still well below its long-term average.

If gold were protection against inflation, its price should therefore have fallen recently as the danger of inflation has receded. That this has not happened reinforces the conclusion of research by Claude Erb and Campbell Harvey. The return on gold, they say, “has not been driven by realised inflation.”

Why, then, has gold risen? My chart shows the reason. For years, the gold price has moved almost perfectly in inverse lockstep with interest rates, measured here by the five-year yield on US inflation-proofed bonds. Gold is high because interest rates are so low.

There’s a simple reason for this. If you hold gold you are missing out on the interest you could get if you held cash or bonds instead. When interest rates are high, this makes gold unattractive and so its price should be low. But when interest rates are nugatory, gold is more attractive and so its price will be higher.

But there’s something else. There’s also been a strong correlation in recent years between the gold price in US dollar terms and sterling’s trade-weighted index. When the pound is weak, gold does well even in dollar terms, giving especially nice gains for a sterling-based investor. During the 2008-09 crisis and after the 2016 vote to leave the EU sterling fell and gold rose. The fact that we’ve seen the same combination so far this year merely continues this pattern.

All this tells us that gold insures us against four nasty risks.

One set of risks are hits to economic activity. These could be short-term recessions of the sort we’ve seen this year. Or they could be an intensification of longer-term secular stagnation. Either would tend to depress bond yields – which would raise the gold price.

A second, related risk is low returns on financial assets generally. Anything that depresses cash and gilt yields even further would of course be terrible for savers. If we hold gold, however, its price would rise to partly compensate us for this.

Thirdly, gold protects us from anything that depresses investors’ appetite for risk. The pandemic and financial crisis differ in many ways, but they share one feature – a collapse in investors’ appetite for risk. Such falls weaken sterling, because the currency is seen as a risky asset. But it also boosts demand for gold as it is seen as a safe heaven. In this way, the metal protects sterling-based investors from any deterioration in global investors’ sentiment.

Fourthly, gold protects us from bad news about the UK economy. Anything that depresses our economic prospects will probably weaken sterling. This would give us profits on gold in sterling terms, but also perhaps even in dollar terms too, given the negative correlation between sterling and gold’s dollar price.

All this tells us that gold bugs are half-silly and half-sensible. They are silly because gold is not linked to inflation. (At least not in the short-term: Messrs Erb and Harvey point out that gold has kept pace with wages since the time of Emperor Augustus, but unless you are the bursar of an Oxbridge college you probably don’t have a 2000-year investment horizon.) But they are sensible to recognise that gold protects us from some nasty risks.

But of course, insurance doesn’t come for free. If the world economy heals better than expected, bond yields would rise and gold would therefore probably fall.

Such a risk is real. But it’s no disaster. In such an event, equities would probably do well, so what we lose on gold we would win on them. In this sense, gold has a place in many cautious well-diversified portfolios.