I ran this chart in the Quarterly Inflation Outlook released 3 weeks ago or so.

Here’s what I wrote:

In general, gold behaves like a very-long-duration inflation-linked bond with a zero coupon. This makes sense – if we were to issue a bond that, in exchange for the current gold price, offered to pay the bearer no coupons but redeem for 1 ounce of gold in 100 years, it would have the same payoff as holding one ounce of physical gold for 100 years. If gold is a true inflation hedge over time, which means its price rises with the price level, then that bond would have the same payoff if we defined the payoff not in terms of an ounce of gold, but in terms of the change in the price level over that 100 years. And that would be a 100-year zero-coupon TIPS bond.

So, we tend to see over time that the spot gold price tends to track pretty well to the implied price of a zero-coupon TIPS bond. The chart above (Source: Bloomberg and Enduring calculations) illustrates the stark divergence which started roughly when the Fed began its tightening campaign. We do not have a very good explanation for this divergence, other than to postulate a clientele effect in that perhaps gold investors are more animated by inflation and TIPS investors tend to be less-excitable institutional owners. Whatever the cause, at the moment gold represents a TIPS bond that is yielding about -2.25% real yield, or roughly 435bps expensive. Unfortunately, relative value observations like this have no mechanism to force them to close, so we cannot recommend selling gold and buying TIPS as an arbitrage. However, we are comfortable saying that investors could create a significantly better-performing commodity index by leaving gold out of the index, or by replacing gold in the index with a TIPS bond. Call Enduring Investments if you are interested in creating such an investment!

At the time, I wasn’t aware (because I don’t track gold flows – gold to me is just another commodity, albeit one that has a very high real duration and a pretty low inflation duration) that China has been buying gold consistently for a year and a half. That only became apparent to me recently when news stories highlighted that China has stopped the accumulation for now. Here is a chart from Bloomberg of China’s monthly gold reserves. It certainly seems as if the timing of the Chinese purchases correspond reasonably well with the divergence in the first chart above.

However, I am not sure that’s the true reason although it is probably a contributor. If you back up and look at China’s reported reserves over the entire period covered by the first chart above, you can see that the recent increase is the largest since 2015…but certainly not the largest on record. Even if the jumps on the chart are due to less-regular reporting updates, the overall rate of increase prior to 2016 was not dissimilar to that of the last 18 months. And yet, that buying did not cause a divergence of any meaningful amount on the first chart above.

So I am back to thinking that this is a broader clientele effect, of people who responded to the biggest spike in inflation in 40 years by buying an asset that historically has sort of a meh history of protecting against inflation over short or medium periods, and a much clearer history of large yield sensitivity. If that’s the case, then while there’s no trigger for closing the gap we should expect that the gap will, eventually, close. Which preserves the implication I mentioned in the Quarterly Inflation Outlook: prudent investors should consider lightening the allocation to gold in their commodity allocations.

As an aside, the title of this piece comes from a song by the Doobie Brothers that I can’t get out of my head now, and hopefully neither will you!

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