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Gold serves numerous functions as an investment. Traditional reasons for
investing in gold include:
- Inflation
- Investment market
declines
- Burgeoning national
debt
- Currency failure
- War or other extreme
events
- Social unrest
Some would argue these entire phenomenon are
related. For instance investment market declines can lead to war which can be
followed by inflation which can lead to currency failure – just look to
Germany in the 1920s for proof of this (albeit in a mixed order of events).
Basically, gold is protection against various ugly or undesirable
societal, political, economic and financial occurrences. That reasoning
broadly explains gold’s rise from $650 in 2007 to approximately $1800
today. Gold has risen over the last few years on the back of uncertainty and
weakness in major global economies.
But of all the reasons given to invest in gold, the most common traditionally
and the one we hear most often is protection against inflation. Inflation is
often a consequence of increases in the supply of money that don’t
coincide with an increase in the output of goods and services –
basically, higher prices as a result of excess money competing for a fixed
number of goods.
Central bankers can print all the FIAT currency they like which although not
always, will generally precede inflation. Gold on the other hand is
essentially fixed in supply and free from this burden. It cannot be inflated
by central banks. Gold
is essentially the ultimate alternative currency. It is the currency
people head to when their paper currencies are falling to bits, as
we’ve seen over the past few years.
Let us investigate the relationship between inflation and the price of gold
over the past 50 years to see if inflation really is the main determinant of
the price of gold:
 
The R2 value of 0.1065 tells us 10.65% of the variation in the
gold price can be described by inflation. Only one tenth of gold’s
fluctuations being caused by inflation hardly gives
credence to its status as a good inflation hedge.
If we restrict our timeframe to 30 years, the results are even more
revealing:
The relationship actually turns negative! In times of inflation over the
last 30 years, gold has generally lost value.
Clearly there are other, more important factors at play that have a
greater bearing on the gold price than inflation. One must also keep in mind
that during times of economic boom inflation can often run at higher levels,
but gold will not be sought as an investment since stocks and other asset
classes will be better performers.
We hypothesise that rather
than being an inflation hedge, gold is better defined as protection against
currency depreciation.
Currency depreciation is defined as a reduction in the value of one
currency with respect to one or more other currencies. This is relative and
speaks nothing of a currency’s absolute value. Measuring currency
depreciation via exchange rates does not tell the whole story.
If for instance, the USD depreciates 20% against the Euro in a given year it
has depreciated 20% only on a relative basis to the Euro. This
gives us no information about the USD’s absolute value.
Imagine the Federal Reserve doubles the supply of USD tomorrow. And for
whatever reason, the European Central Bank does the same and doubles the
supply of Euros. In very basic supply & demand economic theory one would
expect no change in the EUR/USD exchange rate and hence if that was the
currency pair one used to determine the value of the USD they would say it
was just as strong as it was yesterday. On a basis relative to the Euro they
are correct, but on an absolute basis the dollar has depreciated
significantly as a consequence of rapid monetary expansion.
The very nature of FIAT currencies necessitates perpetual increases in
the supply of money, at an exponential rate. From day one, every FIAT currency
has gradually depreciated. That is why goods in the early 20th
century cost a fraction of what they do now, not because they were cheap
then, but because the dollar was more valuable.
This is where the lines between inflation and currency depreciation are
blurred. One could say that over the last 100 years the value of the USD has
gradually deteriorated due to inflation. The flipside of that argument is
this “inflation” is actually inherent in our monetary system and
is attributable to the ever increasing supply of money that is a mathematical
necessity with FIAT currency.
To illustrate the difference between inflation and currency depreciation we
return to the 21st century. QE1 was launched in late 2008 as a
response to the dire financial and credit market conditions as a result of
the global financial crisis (GFC). QE1 involved the Fed purchasing around $2
trillion in mortgage backed securities and treasuries. The catch is they did
it with newly created or “printed” money, and hence the money supply
rose by around $2 trillion in little over a year.
Predictably, this reduced the value of the USD as it became far less
scarce.
As we mentioned earlier, to gauge the actual value of a given currency
one must look past its value relative to another currency.
The USD index on the above chart measures the relative
value of the USD against a basket of currencies. When the Fed
printed $2 trillion during QE1 the value of the USD deteriorated almost 8%
relative to other currencies.
Can we say this was an absolute depreciation in the value of the dollar and
not just relative to other currencies? In this specific scenario, the answer
is yes. The GFC emanated in the US and hammered their economy and financial
system harder and earlier than most. Hence, the Fed had to act before most other
central banks did. Consequently, the monetary expansion and currency depreciation
we’re now very familiar with worldwide began in the US with QE1.
Therefore, the 8% net fall in the value of the USD over QE1 is indicative of
an absolute depreciation in its value.
Now we’ve established QE1 = expansion of the money supply and
supplementary USD depreciation, we can illustrate the difference between
currency depreciation and inflation.
If currency depreciation and inflation were one and the same we’d
expect a rise in inflation to coincide with QE1 (blue segment above). That
did not occur to the extent many believed it would. Although inflation
increased (from a deflationary environment) it still stayed low and has done
for a significant period of time.
If one had of taken the traditional, one dimensional view that gold =
inflation hedge they would have expected a very low return from gold over
that period. Here’s what they would have missed out on:
Gold rose nearly 50%, coinciding with a 7.84% drop in the USD index, and
all the while inflation remained contained or even negative.
Those that correctly identified gold’s fundamental value as
protection against currency depreciation would have done very well for
themselves during QE1, since, and going forward. Those that
predicted low inflation and stayed away because gold = inflation hedge would
be kicking themselves.
Those that claim gold = inflation hedge are not absolutely incorrect. Generally,
inflation and currency depreciation are very closely linked and correlated. When
one sees a spike in inflation and a corresponding increase in gold, cause and
effect tells them gold = inflation hedge. What is actually happening is
currency depreciation followed by, and visible in, inflation. Gold then rises
with this increase in inflation. The root cause remains currency
depreciation, and inflation is sometimes the most obvious embodiment of that
phenomenon - so the two can be confused.
We’ve investigated the relationship between inflation and various
other commodities, indexes and currency pairs. Among the commodities, corn,
silver and copper were even weaker inflation hedges than gold.
The best inflation hedge we found is crude oil:
The relationship here shown by the R2 value is stronger than
that of the other commodities, but still far from convincing. This tells us
in times of inflation one is better off buying crude oil futures, or perhaps
way out of the money call options on oil, as a hedge against diminishing
purchasing power. This is quite a sensible conclusion. Crude oil is one of
the most common input costs. In Western economies almost all goods have the cost
of oil implicit in their price. Increasing oil prices cause an inwards shift
of the short run aggregate supply curve, driving cost inflation.
Since 2007 the US’s oil consumption has tailed off somewhat, and
hence oil is less of a determinant of inflation than it once was. However oil
consumption has been tracking up in unison with GDP growth since 2009.
Whether this trend continues is open to speculation. For the foreseeable
future we predict oil will continue to be a better inflation hedge than gold.
If one is worried about inflation, buy oil.
If
one is worried about slowing growth, currency depreciation, political and
financial certainty, unemployment and war, buy gold. Gold
will generally perform given any of these scenarios. It is a far more diverse
investment than oil which is best in times of inflation or strong growth. We
see neither strong growth nor high inflation in the coming years.
Gold is essentially the best hedge against loose
monetary policy and active currency depreciation by central banks.
The Fed’s response to lagging growth and persistent unemployment will
be further rounds of QE. QE3 has been launched within the last month and sets
the stage for the Fed to print at least $40 billion per month for the next
three years or more. This means more monetary expansion and currency
depreciation and is likely to send gold much higher, as it did during QE1 and
QE2. To make the most of this please visit our website and consider
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