Gold has been considered a store of wealth since ancient times. It is beautiful, malleable, and scarce – all qualities that would have made it appealing to both potentate and subject alike. Its beauty malleability allowed it to be used for jewelry and gilt, while its scarcity made it a valuable currency – first as coinage, later as backing for currency. In modern times, it no longer backs currencies but is instead considered a store of wealth that provides a valuable hedge against inflation. Why then, if inflationary fears are percolating, is gold a relatively stagnant investment?

The logic for gold as an inflation hedge is sound. The currency of an inflationary economy is experiencing reduced purchasing power. In other words, it requires more currency to buy the same amount of goods. A gold bar or coin contains a fixed amount of metal and is generally fungible. In theory, that metal will appreciate in local currency terms as the purchasing power of that currency decreases. That works spectacularly well in countries that are forced to borrow in currencies other than their own. The foreign currency borrowing makes them subject to periodic devaluations, which makes gold a wonderful hedge against currency depreciation. 

For most investors in G-7 countries, however, that problem is seemingly eliminated. They can borrow in their own currencies. While their currencies are subject to fluctuation, they rarely find themselves in the midst of a currency crisis. We must ask ourselves then, what does gold buy an investor who lives in a country with low inflation and a stable economy?

Right now, not much – at least on the inflation front. We have seen industrial commodity metals like copper and aluminum rising over the past few months as the world’s economies rebound, or at least expect a rebound. While gold is also an excellent electrical conductor, its scarcity and use as a store of wealth work against the yellow metal in this regard. Demand may be picking up for many useful metals, but gold is less useful than most.No one is going to wire a building with gold in lieu of copper. It’s simply too expensive. 

The following graph shows the relationship between the SPDR Gold Shares ETF (GLD) and the iShares TIPS Bond ETF (TIP). The TIP ETF holds US Treasury obligations that are protected against inflation.TIP performs better when inflationary expectations increase the demand for those obligations. I chose those two instruments because they are easily comparable, with standardized units both priced in US dollars. We can see that while the two instruments moved largely in tandem over the past two years, TIP has outperformed GLD since the November election.

Two Year Chart of GLD (white) vs. TIP (orange) with 100 Day Percentage Correlation

(Click on image to enlarge)

Source: Bloomberg

The lower portion of the graph shows the correlation of daily percentage moves over the prior rolling 100 day period. We can see that prior to the Covid-related panic of a year ago, they correlated quite well. The readings were in the 0.60-0.70 range, which is not perfect but shows a definite relationship. The correlation broke last March when gold outperformed TIPS – as it should have – but the correlation has yet to return to its prior levels. Gold is simply not correlating well to inflationary expectations right now. 

Thinking back to the purchasing power discussion a couple of paragraphs earlier, we need to consider how gold is priced. Gold is typically priced in US dollars, meaning that a buyer exchanges a given amount of US dollars for an ounce of gold. In this case, it is best to think of gold as one other exchange rate. Exchange rates change when the purchase of a given amount of foreign currency requires a different amount of US dollars. I find it useful to use the US Dollar Index (DXY) as a proxy for the relative strength of the US dollar against a range of foreign currencies. In the chart below, we compare GLD to DXY over the same time period as in the prior graph:

Two Year Chart of GLD (white) vs. TIP (orange) with 100 Day Percentage Correlation

(Click on image to enlarge)

Source: Bloomberg

Here we see that the relationship between gold and the dollar is largely inverse. That makes sense, given the nature of exchanging dollars for gold and vice versa. In this case, the two started out with a relatively high inverse correlation that was declining throughout the 4^th quarter of 2019. The correlation reached a low in the post-Covid crisis – again sensible considering the save haven status of the metal. Over the past few months, however, the prior inverse correlation has returned. It appears to be solidly in place.

In sum, gold is not acting as a particularly good hedge against inflationary expectations, but it has acted well as an “anti-dollar”. The problem for gold over recent weeks is that the dollar has strengthened as interest rates rose. Interest rates are rising along with higher inflationary expectations, but those are pushing up the dollar rather than a classic inflationary hedge. This has been a headwind for gold bugs in recent weeks and could remain so until or unless investors change their focus back to treating gold more as an inflation hedge than a currency hedge.