Gold not an inflation hedge, despite what people think

Tapering of Fed stimulus, rising rates, strength in the US dollar to hurt bullion prices even more

PUBLISHED : Thursday, 18 July, 2013, 12:00am
UPDATED : Thursday, 18 July, 2013, 4:17am

As US interest rates have risen, owning gold has been a loser's game for anyone trying to hedge against inflation. Gold isn't a smart inflation hedge, but many have been using it that way because they think they have few alternatives.

A low inflation rate has been punishing to gold investors for the past three months, and the consumer price index (CPI) has been holding well under 2 per cent this year. As evidence, the leading gold bullion vehicle, the SPDR Gold Trust exchange-traded fund (ETF), has lost nearly a quarter of its value over the past year as investors continue to sell out of their positions.

Stocks of gold-mining companies, which can get bruised even more than spot metal prices, have fared worse. The Market Vectors Gold Miners ETF, which holds firms such as Barrick Gold, has lost nearly half of its value so far this year.

To be fair, gold prices have rebounded in recent weeks. Gold reached a near three-week high after US Federal Reserve chairman Ben Bernanke hinted a highly accommodative policy was needed for the foreseeable future. But, at about US$1,285 per ounce last night, gold is nowhere near its high of US$1,889 in 2011.

Will the slowing down of the Fed's cheap-money machine ratchet up interest rates even more? The tapering of its "quantitative easing" programmes may or may not lead to inflation. Nevertheless, rising rates - and resulting strength in the US dollar - hurt gold bullion, which doesn't pay dividends or interest.

One of the biggest downers for gold owners - in addition to plummeting prices - has been the idea that inflation was threatening the US economy.

Since the 2008 meltdown, the United States has been in deleveraging mode, which is disinflationary. Wages have been stagnant and consumer prices tame. Gold rarely makes sense in a low-inflation, slow-growth economy.

Perhaps investors woke up to that fact en masse over the past three months when it became apparent that the Fed said it was more confident that the US economy was firmly on a sustainable path. By June 28, gold had posted its biggest quarterly loss on record - falling 23 per cent to US$1,180.70 an ounce.

Apart from money-market funds, a less skittish way to hedge inflation is through Treasury inflation-protected securities (TIPS) funds. While TIPS yields are also lacklustre in a low-inflation environment, they can protect against longer-term inflation expectations. Because they are indexed to consumer prices, they are much less volatile and boost yield when inflation rises.

The iShares Barclays TIPS Bond Fund, traded in the US, holds inflation-indexed bonds. With a 4.7 per cent annualised return over the past three years, it has returned more than twice the SPDR Gold Trust, which has gained only about 2 per cent over the same period.

Year to date, though, the iShares fund has been disappointing, showing a 7 per cent loss, which compares favourably with the 23 per cent loss posted by the SPDR gold fund.

Why would I recommend a fund that has lost money? Because I think that although short-term inflation fears have been wrong, prices will accelerate across the board as the economy heats up in coming years.

Now's the time to buy TIPS, not when inflation is in full force. If the economy continues on its upward trajectory, prices usually follow. The latest US jobs report showed employment growing faster than expected.

So far, inflation hasn't been a problem. The latest CPI report put the annual US inflation rate at 1.4 per cent to May. Last year it was under 2 per cent. You have to go back to 2007 to see the highest annual cost-of-living change since the 1990s (4 per cent).

Despite the rebound in gold prices the dollar's rebound and US interest rate increases will make gold even more undesirable.