Gold doesn’t protect us from inflation. This is one thing we’ve learned from the current inflation scare.
Since last July inflation expectations have soared: the five-year breakeven inflation rate (the gap between conventional gilt yields and index-linked ones) has risen from under three percentage points to over four. And during this time the price of gold has fallen almost ten per cent in US dollar terms and 12 per cent in sterling terms. The metal, then, has failed as insurance against inflation fears.
Which shouldn’t be a surprise, because the link between it and inflation expectations has been weak for a long time. Since 2000 the correlation between five-year breakeven inflation and the sterling price of gold has been 0.25. That means that higher inflation expectations are more likely than not to be accompanied by a higher gold price – but not so much so that you can rely upon it. In 2013, for example, inflation expectations rose but gold fell more than 20 per cent.
There’s a simple reason for this. It arises from the fact that gold does not pay interest. This means that when bond yields are high, you lose a lot of income if you hold gold. The metal will therefore be unattractive and its price low. At lower interest rates, however, the loss of income is smaller and so gold is more attractive and will command a higher price. This means that the price of gold is driven largely by bond yields. As yields rise gold falls and as they fall gold rises.
Hence the pattern in my chart. It shows that the gold price soared as yields fell between 2007 and 2012, fell back as yields rose in 2013-14, but then rose as yields fell. Recent months have continued the pattern. Bond yields have risen since last summer, and so gold has fallen. Because that rise in yields has been caused in part by fears of higher inflation, gold has failed to protect us from such fears.
If you fear that bonds will continue to sell off because of the prospect of higher inflation, you should therefore expect gold to continue to drop.
This is not to say the metal is useless for investors. Quite the opposite. The fact that it rises when bond yields fall tells us that it does well when investors lose their appetite for risk – which is when shares fall. Gold is therefore protection against big losses on equities: it rose nicely during the 2008-09 crisis and during the worst of the pandemic, for example.
This is especially true for us UK investors. Because sterling is a relative risky currency it falls when global investors become nervous. Which means that sterling-based investors then see profits on safer assets that are denominated in foreign currency, as gold is.
All this, however, poses the question: if gold doesn’t protect us from inflation, what does?
Recent history suggests that equities do: there’s been a good correlation between breakeven inflation and the All-share index since 2000.
This, however, might be misleading. For most of the last 20 years breakeven inflation has been cyclical, falling in recessions and rising in recoveries. Because equities are also cyclical, this means there’s been a correlation between the two.
Correlation is not causality, however. This does not tell us what would happen if breakeven inflation were to rise so much as to threaten significant rises in interest rates. It’s quite possible that in such a scenario equities would suffer either as investors dump them in favour of higher-returning cash or because they would fear that higher rates would cut economic growth. Cyclical stocks might be especially hard-hit by this: do you really want to be holding housebuilders if the Bank of England is raising rates significantly?
Instead, better protection in such a scenario might be cash. The point here isn’t just the obvious one that it wins from higher interest rates. It’s that the worst-case loss on cash is small – no more than the real interest rate – whereas worst-case losses on bonds, gold or equities are much larger.
Of course, this isn’t an exciting answer. But then, insurance isn’t supposed to be exciting.
Personally, I think sustained high inflation is a low probability. But no sensible person invests on the basis of some guy’s opinion. It’s the full range of probabilities that matters. Risk is probability times impact. And even if serious inflation is a low probability it has a high impact and so should be guarded against.
