“Bought gold at 1,738 today,” texted a friend a few weeks ago, “hope this was not a mistake.” Any meaningful judgement would, of course, depend on one’s views on the immediate future of the world’s major economies and the markets serving them. But it also needed to establish the purpose of gold buying: to achieve a sensible return on investment, or to grab a sedative against unquantifiable market pains?
My friend, as I know him, is a the-end-is-nigh type of person. He sees political incompetence and crooks proliferate, bubbles in all markets, private and public credit excesses too reckless to be brought under control and an inflation surge beyond the point of return. Like most Europeans, his thinking is formed by the continent’s history of inflationary destruction, and he sees gold therefore as the last asset class standing. He hopes to have the last laugh all the way to his safety deposit box. He expects to kill his headaches and to make a killing with his portfolio at the same time.
Retail investors are evenly split between gold bugs like my friend, for whom gold is the yardstick of everything, and the light-hearted, who view gold as an obsolete relic dating back to a time when the earth was flat. As inflation protection, gold has a chequered history. When the Spanish conquistadores struck gold in the New World by robbing and killing the indigenous population of Latin America, rivers of gold flooded into the Old Continent, triggering an unprecedented surge of inflation.
The same happened to the US during WWI, when defence orders from Europe paid for in gold led to unsustainable growth and credit expansion, ending in the Great Depression. The thing with gold is that its inventory has built up over millennia, so strictly speaking it is a means of exchange slowly debased by continuous mining.
The gold price may have hit a nominal all-time high in August last year (USD 2,067.15), but adjusted for inflation this is still way below the USD 2,214.78 reached in real terms February 1980, when inflation in the US had peaked.
Very little gold is consumed by dentists, electronic manufacturers and other industrial applications. Jewellers do not consume gold ‒ they merely transform its physical appearance. When times get tough we sell our family heirlooms, and not very profitably, for that matter. Gold yields nothing. It is rarely shortened. People who go long on gold hope for prices to reasonably rise over time, at least nominally.
Chartists have clever ways to make predictions for this purpose, as have ticker-reading day traders. But bull cycles in gold are rare. The last one started when the dotcom bubble burst and ended when the Great Financial Crisis was under control again. Short, pandemic-induced gold buying peaked, as I said, in August last year.
Gold is ‒ in contrast to widely-held beliefs ‒ an ill-suited hedge against inflationary tendencies
What makes market moves somewhat unpredictable is the hard-to-scrutinise selling and buying of gold by central banks and the volatility caused by exchange traded funds that accumulate or reduce physical gold in daily tune with investment flows. Gold, which used to be a hoard of coins or bars tucked away in a safe place, has been dematerialised, manifesting itself only in bank statements and broker slips. This has heightened volatility and harmed its unique selling proposition: to be a bulwark against devaluation, governmental overreach and records-destroying disasters.
As my friend had to realise in the days after his purchase, gold, which does not pay interest, will essentially behave like a zero-coupon bond, a security which does not pay interest until maturity. Interest payments are compounded instead, and typically expressed in a discount on the bond’s redemption amount. Prices of zero-coupon bonds ‒ being the sum of all interest payments and the principal ‒ therefore react keenly to interest rate movements. Gold does the same. Its value will rise when interest rates come down, but fall when rates go up in reaction to inflation jitters.
We have observed this for a couple of months now. Gold is therefore ‒ in contrast to widely-held beliefs ‒ an ill-suited hedge against inflationary tendencies. Only when hopelessness, as opposed to fear and panic, becomes the prevailing sentiment will gold be remembered as a safe haven. Before that happens it will be sold, to meet steepening margin payments for instance, or to salvage national current accounts.
As gold is bought and sold predominantly in US dollars, exchange rates also matter greatly. A weakening dollar boosts the attractiveness of all dollar-priced commodities, including gold, which will be fairer to buyers based in other currency zones. It becomes a play on exchange rates. That’s the crux of my friend’s inflation fears.
He dreads the wall of liquidity injected into the US economy by the FED and the unprecedented fiscal stimuli dispensed first by Trump and now by the Biden administration, which aims to ‘go big’. Just shy of two trillion US dollars have been gifted to households and states, to municipalities and corporations, and now a further two trillion are in the pipeline for infrastructure and green investments. He sees the recent, dramatic rise of long-term interest rates as a sure sign that money debasement is imminent.
We do not know how the US’ rather unique experiment will end; whether inflation will just flash up to then moderate, as many believe, or if we will live again through the inflationary hell of the 1970s. Yet for the time being, optimism about America’s economic recovery, doped with those lavish handouts and unfettered by a highly successful inoculation campaign, carry the day. As a result, the US currency is appreciating, supported additionally by widening interest rate differentials with other currencies, most notably the euro. This is bad news for gold investors.
It always takes much longer for gold to appreciate in value than we would expect, as I have tried to outline above. In real, inflation-adjusted prices this may not happen at all. But this is not the only bad news for my friend. This time around, gold bugs will be tested for their patience even more cruelly than in the past. Millennials and the Robinhood-gambling Generation Z have no emotional attachment to gold. They see the strictly limited supply of Bitcoin and other crypto currencies as a much handier tool to bet against inflation, and many professional investors seem to agree.
Rising investment in cryptos will corrode the inflation-busting credentials of gold and its importance as an investment class. As a greying member of Generation X, I wonder why nobody seems to be bothered by raided e-wallets, malware and many other crypto frailties. Gold coins had at least the power to endure. For my friend and his hasty investment in gold to turn a profit, not even entrenched inflation will be much of a help. What he’d need is a thunderous crash of Bitcoin instead.
The purpose of this column is to broaden readers’ general financial knowledge and it should not be interpreted as presenting investment advice, or advice on the buying and selling of financial products.
Andreas Weitzer, Independent journalist based in Malta