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Posts Tagged ‘inflation protected products’

11
Feb

THE INFLATION GHOUL KEEPS GOLD IN THE SHADOWS

   Posted by: Mr. Gold    in Uncategorized

One of the common misconceptions about gold prices is that they correlated tightly with CPI numbers. Any such trade is doomed to fail, as much as an equally mono-dimensional bet on long term yields on the back of a central bank’s interest rate decision. Both relations fail to factor in the market anticipation ex ante, the way these expectations have already been priced in (“is the interest rate decision chasing runaway price pressure” vs “is the interest rate hike offsetting future price pressures”) and the time lag. In fact, over years, gold prices have exhibited a much tighter (inverse) correlation to M2 growth – which takes into account both visible and shadow money creation (growth of money creation through expanding collateral acceptance). Gold is telling us much more about a broad-based purchasing AND investing power of specific currencies, rather than some adjustable, narrow consumption index with all its comparative intricacies between “core” and “headline”.

In this light, the price action since the beginning of the year has been particularly demonstrative. While the spread between regular treasuries and inflation-protected bonds in most countries points to increasing inflation expectations, gold has relinquished some of the last year’s gains. Those gains had come in two large waves. First around the Greek crisis in May – in anticipation of a near term monetary response offsetting the longer term grind of disinflationary austerity measures. The second wave was triggered by Bernanke’s speech in August and subsequent QE2 anticipation from September onwards. As we noted last week, the price impact of this event on the economically inert gold has been less pronounced than the appreciation in many other commodities, including base metals and agros.

Yet last year’s flight to quality was also characterized by a consistent rush into the perceived safety of ever-lower yielding sovereigns, most notably the Bund. The actual advent of QE coincided with the peak of that Bund rush. Yields have now mostly rebounded from their cyclical lows. And gold has recently been affected by ETF redemptions. A more granular analysis across various currencies is necessary to understand to what extent the leading indicator of inflationary pressures has now largely fulfilled its role.

We do this by comparing the differential in yield increase between regular Treasuries and inflation-protected bonds among the 10 economies which offer such products. Not surprisingly, we find that among the developed economies it is the UK which has registered the highest jump in yield spread between gilts and inflation protected securities (21bp, as of last Tuesday). The Eurozone bond markets are far from uniform (Germany 19bp, Italy 13bp and France 11bp). Australia has seen a 13bp increase in yield spread, US 5bp and Canada only 2bp.

It appears that much of these trends are mirrored by the way in which the FX market treats the respective gold (or losses) for investors whose wealth is denominated in the main currencies. In fact, as of last Tuesday, gold in UK pounds has lost most since the beginning of the year (-7.21%), followed by losses in Euro (-5.65%), US dollar (-3.60%), Australian dollar (-3.32%) and Canadian dollar (-3.43%). In other words, the “dollar” currencies have been the weakest performers vis-à-vis gold. It also appears that these economies’ increase in real yields happens to mirror real economic activity, rather than increased inflationary pressures.

Some scoff at GBP’s renewed strength – possibly predicated on the expectation of further increase rate hikes in future. Others point to China’s relentless upward (buying) pressure on deeper bond markets outside the dollar zone. The fact of the matter remains that the FX market is beginning to do the job of the gold investor both in the UK and in the Eurozone, bidding up the currencies whose monetary authorities may be forced to adopt a more hawkish position. The reduced risk aversion may even further accelerate the yield rebound in Germany.

But there is one outlier – where inflationary pressures do not cause the market to bid up the currency. The Australian dollar – eternally affected by the Japanese money flows – is currently suffering from China’s own growth trajectory jitters. Aussie’s relative weakness ensured that gold price losses down under have been limited since the beginning of the year, despite the fact that the 8bp rise in 10 year (inflation-protected) yields has been outpaced by the 21bp jump in regular treasuries. This positions the Aussie somewhere around the equally inflation-prone Italy, which however is being protected from stronger price pressures (and imported inflation) by a robust Euro. Should the emerging market (and China bearishness) prevail in the near future, and RBA continue with its counter-cyclical interest rate policy enshrined since the days of Governor Macfarlane, then Australian commodity producers could soon reap big benefits in terms of weaker (nominal) currency and concomitant margin expansion. Sooner or later, the gap between the nominal and real value of the currency will close – but in the near term, the Aussies may be in a sweet spot.

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