An illusion of safety
Gold investing has generally been promoted as a safe storage of value for high anxiety and inflationary times. Examining historical data reveals a very different reality: gold is neither a reliable inflation hedge nor a safe, predictable anxiety cure.
First, the biggest determinant of gold prices is not inflation as many people believe. Second, as we have observed this year, gold investors can experience sudden and significant losses, even as anxiety still roils markets.
A bit of history
Gold is widely known as one of the oldest storage of value. Very early on, gold was associated with gods, immortality, and wealth. Over the last 3000+ years many currencies have come and gone, but gold remains a medium for storing and exchanging value.
pharaoh Tutankhamen’s 240 lbs solid gold coffin at the Egyptian Museum in Cairo
Following World War II, the gold price was fixed at $35 per ounce until August, 1971. After that, the price of gold started to move up and down depending on whether short term interest rates were above or below the rate of inflation.
What determines the price of gold?
The lion share of price movements, depend on a single factor: whether real interest rates are positive or negative. Even without closely looking at the numbers, the attached chart makes it strikingly apparent that negative values for real interest rates often coincide with positive returns for gold and vice versa.
For most of the 1970s the rate of inflation remained higher than short term interest rates (meaning real interest rates were negative). Money parked in savings accounts, CDs or money market accounts was losing purchasing power. As a result of this sustained negative real yield on savings, the price of gold has increased dramatically during the 1970s.
We have again experienced negative real interest rates after 2001. Gold rallied even as inflation remained benign; because short term interest rates were pushed so low they no longer provided a positive real yield.
Despite the fact that inflation was higher than it is today, the price of gold experienced significant declines during the 1980s and 1990s. During these two decades short term interest rates were sufficiently high to provide a return over and above inflation so gold no longer held much appeal.
Fast forward to today: gold price is down 23.5% so far this year. Why? The market began to anticipate that real yields on savings may turn positive sooner than initially anticipated.
Other variables, such as central bank purchases or sales, as well as the physical demand for Jewelry in India and China may also influence gold prices at the margin.
Is Gold worth considering at this point?
One of the rationales to make a change in portfolios is if the initial reason for purchasing an investment no longer applies. We have recently eliminated gold positions from portfolios once the Federal Reserve began to signal its increasing commitment to reducing monetary stimulus sooner than originally anticipated.
As we have been recently reminded, no one can successfully and consistently time markets. Gold could still rally in the short run if markets perceive that the Federal Reserve’s latest talk of reducing stimulus and normalizing monetary policy was just a “pump fake” meant to let some air out of the stock market.
On the other hand, if markets increasingly believe that interest rates are likely to rise above the inflation rate, gold may extend its recent losses and be in for a long rough ride. Gold returns have historically been uncorrelated to both stocks and bonds, thus for diversification purposes a measured gold position may prove helpful for certain investors at times for certain investors.
Andrei Voicu is Chief Investment Officer at Fragasso Financial Advisors, a Pittsburgh-based investment and financial planning firm. Due to industry regulations, comments are not permitted on this blog. If you would like to contact the author, please email us at email@example.com. Andrei can also be reached for comment at 412-227-3200.