21 January 2011

Gold Price and Bond Yields Are Telling Different Stories – Are They?

Recently my attention was brought to the matter that gold price and bond yields are telling different stories, and that this inconsistency cannot last long. Sooner or a bit later one of them, either gold price or bond price will fall sharply. The story of gold price is that we will see galloping inflation. At the same time low long-term bond yields clearly indicate low inflation expectations. The figure below illustrates this (seeming) inconsistency between gold price and bond yields.

We see that over a very long period, from 1925 to 2000 or so, gold price and long-term bond yields have more-less agreed. The rules of money changed in 1971 (since then the value of money is no more tied with gold), but still, the story of gold price and bond yields had been quite consistent. Furthermore, there was a clear connection with inflation. Looks like something game-changing has happened since 2000: this long historical pattern doesn’t seem to be valid any more, gold price has jumped through the roofs.

Before declaring that “This time it’s different, everyone go and buy gold, gold prices will never fall,” let’s think a bit. The question is: why there is such a discrepancy? How can it possibly be? If the story of gold price is true, have lenders gone crazy when lending with such low yields? If the story of bond yields is true, we should soon see a sharp fall in gold price – but is it?

First, in 2000s rules of money indeed changed once again. This change wasn’t some event that happened over night as it quite was with the debasement of money in 1971 when US government suspended the convertibility of the US dollar to gold. Instead, it was gradual and started already in 1970s with the invention of securitisation and every kind of other modern financial instruments. These new instruments and structures basically made it possible, to lend unlimited amounts of money by create debt without creating deposits fast (see my earlier post “Securitisation – Fast Way to Create Debt” for further explanation of this). Furthermore, combined with the complex statistical modelling, they also led to the false sense of security. In 2000s together with the relaxation of regulatory frameworks, this process of change accelerated remarkably. In result, money supply cannot be controlled or even truly monitored any more. The amount of money is clearly excessive, but not rightly distributed. Instead, bubbles occur more easily here and there.

The above justifies rise in gold price. There is clearly reason for believing that the value of “fiat money” will go to zero – and rather soon. Recent financial crisis, quantitative easing / printing money for dealing with its consequences and the buzz around it have made people nervous and prompted many to shift into gold.

The above also provides a partial explanation of why the price of long term money is so low for governments with strong credit ratings, such as U.S. As money supply has increased, its price has gone down. But it’s not just about the supply of money. It’s also about the increasing demand for safe investments. China needs to invest its 2.5 trillions of dollars or more of foreign exchange reserves into something, and Japan its ~$1 trillion. Growing amount of people’s savings in pension funds shall be placed into safe instruments like AAA-rated government bonds. Banks are obliged to have certain liquidity reserves, and resent liquidity crisis together with the new Basel III requirements have only increased the demand for low-risk liquid assets. Considering the austerity measures already introduced or intended by European governments, the supply of government bonds is rather limited for satisfying all the demand.

One question might be why China and Japan are not investing their reserves into gold. Well, they are: in December 2010 China (the sixth-largest holder of gold) had 1,054.1 tonnes of gold and Japan (the ninth-largest holder of gold) 765.2 tonnes. One thing is that there is not enough gold for sale to satisfy all the possible needs of these countries. Namely, even at current prices, gold forms only about 1.7% of China’s forex reserves and 3% of Japan’s forex reserves respectively. (The data are from Wikipedia.) So these countries have chosen the so far second-best alternative: U.S. treasury securities.

Now we have also explained why bond yields are as low as they are. But what happens next? Will gold prince go down or bond yields go up (and thus, bond prices down) or both? There is no single true answer. Each of these alternatives may materialise. If the perceived credit risk of U.S. and the other developed countries increases (e.g. because of the uncontrolled spreading of the debt crisis of PIIGS countries), bond yields will increase considerably and gold price will continue to climb fast. If nothing unplanned (like bursting of China’s real estate bubble) happens, the sovereign debt crisis in EU is managed well and economy starts picking up (which is the base scenario according to IMF, OECD and many others), gold price will be lower after two years than it is today. We will also see some increase in bond yields (and respective fall in bond prices) that is in line with central banks increasing interest rates. If some important player decided that gold price is by far too high right now, and started selling, we would speak about bursting of the gold bubble. 

To conclude, I think that gold price and bond yields are not telling different stories. They just present the two sides of the very same medal: too much money that is used inefficiently.

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