Predicting Inflation: Gold versus Bonds

Predicting Inflation

In my most recent market commentary, dated 2/9/10, I discussed how sensitive market prices are to future inflation expectations. To the extent that you can discern whether the market expectations for future inflation is too high or too low, you should be able to beat the market by using tactical asset allocation. During the market chaos of early 2009, long run inflation expectations had fallen to 1.0%. If you were able to predict that the federal reflation efforts would be successful (at least in the short term) and that market inflation expectations would rise to where they are today (2.6%), you could have caught the market bottom and benefitted from the 70%+ run up in the S&P since that time. I was too pessimistic and missed most of the run-up.

In normal times, the market appears to view 2.5% as the natural long-term inflation rate. The Fed claims to view 1.5-2.0% as its desired inflation rate. In my market equilibrium model, I have used 2.25%, but have tended to favor a range of +/- 0.25% with the acknowledgement that market outcomes aren't that precise. My general argument has been that the market is too focused on inflation, and that deflation is the primary threat. Many market pundits, on the other hand, have been proclaiming that the market (particularly the Treasury bond market) is massively underestimating inflation.

There are two primary market indicators for future inflation expectations: (1) the Treasury-TIPS spread and (2) the price of gold.

What bonds are telling us

As of 3/26/10, the Treasury curve looks as follows:

If you compare this curve to the curve at year end 2009, you'll see that the nominal Treasury rates have moved up slightly (the 30-year rose to 4.8% from 4.6%), TIPS rates moved up (the 30-year TIPS rate rose to 2.2% from 2.0%) and inflation expectations fell slightly (fell to 2.6% from 2.7%, yes there is rounding involved here). The TIPS curve is steep and the inflation curve less so, which makes sense. Below is what I consider to be the "equilibrium" yield curve, using my 2.25% inflation rate as a target:

The bond market is basically saying that the Fed will be a little slow to remove accommodation (which is why short rates are below equilibrium), but that long run inflation expectations are well-anchored.

What gold is telling us

The gold market is telling us something different. A rise in the gold price tends to lead a rise in commodities prices, which in turn leads a long term rise in CPI. Gold also has a history of volatility and of overshooting its equilibrium, however.

Below is a chart of the price of gold since the 1950s:

The gold price was fixed at its Bretton Woods price of $35 per ounce from the early 1930s to the late 1960s, jumped to (briefly) over $800 per ounce in 1980, fell to a new equilibrium range of around $375 per ounce from the mid-1980s through 1995, fell again in the late 1990s to $250 per ounce, and then rose during the past decade to over $1,000 per ounce.

If gold wasn't so volatile, we could expect it to rise steadily over time as the Fed promotes positive inflation. It should be noted that during the entire century between the early 1800s and the early 1900s, there was no sustained inflation in the United States as the dollar was convertible into gold at $20 per ounce. It is only since the Great Depression that the government has actively promoted inflation. In fact, because of the productivity of the capitalist system, you would expect prices to fall over time as producers became more efficient, not to rise as tends to be the case.

All things being equal, if you were expecting the Fed to target consumer price inflation of 2.25%, and you expect productivity gains of 1.75% per year, you would expect the gold price to rise by a rate of 4% per year to indicate that the dollar is being devalued accordingly.

Despite all the volatility in the gold price and inflation since the 1960s, the long term trend shows that gold has led increases in CPI, less a producitivity factor.

In the chart above, we can see from the trendline equation that CPI has been falling at a rate of 1.8% per year relative to gold since the 1950s, but that the relationship has been volatile. Gold was undervalued relative to consumer prices in 1970 and 2000, was overvalued in 1980, and was fairly valued in the mid-1990s. In many of my models I find that the mid-1990s was a well-balanced economy, before Robert Rubin's dollar bubble and the following dot com and housing bubbles threw the economy off kilter, to put it mildly.

One more factor to take into consideration is that economy-wide prices don't adjust instantaneously. I've found that it takes about 10 years for the overall CPI to catch up to a sustained devaluation of the dollar relative to gold. The inflation rate for the next 10 years is therefore dependent on whether monetary and fiscal policy are tightened enough so gold falls back in line with the current consumer prices, or whether prices keep rising to catch up with the new equilibrium level in gold.

My calculations of the theoretical gold price and CPI reveal the following:

  • If gold has overshot to the high side as a function of the financial crisis, and the treasury market's inflation rates are correct, then the current equilibrium gold price would be $550-600 per ounce.
  • If gold has found a new equilibrium level at the current $1,100 per ounce, then we should expect a 10-year inflation rate of over 5%.

This is a massive divergence.

  • If the bond market is correct, then bonds and non-precious metal commodities are fairly valued, and stocks are slightly overvalued.
  • If the gold market is correct, then most bonds are overvalued, TIPS and commodities are way undervalued and stocks and even real estate are slightly undervalued.

So what market should we listen to, gold or bonds?

The bond market is more liquid and understands the deflationary risks of high leverage. While the argument can be made that Treasuries are overpriced (yields too low) due to the Fed's holding rates too low and to Chinese manipulation. If nominal Treasuries were being manipulated by structural factors, then I would expect TIPS to be yielding nearly 0% across the curve. As can be seen above, however, the TIPS yield curve is showing positive real yields right around their equilibrium levels.

The gold market is a bit more ideological, attracting those that tend to dislike the government in power. It should be said, however, that the gold market was far more adept at tracking the debt bubble of the 2000s than the Federal Reserve proved to be, right through to predicting the extraordinary measures taken in the bubble's aftermath. The political landscape, on the other hand, is implying that consensus is building to fight the deficit, reform entitlements and to rein in financial system leverage. While that may be wishful thinking on my part, it would be hard to make the case that the wind is shifting in the other direction. My view is that the health care bill will be one of the last acts of giving us things for some time. The next decade will be occupied mostly by our government taking things away.

Conclusion

The answer to the debate is not obvious. Risk management, therefore, should be the primary focus for investors. I'll do my regular quarterly market update in a few days, but the lesson for me would be to overweight TIPS, commodities and cash, and to underweight precious metals. At the very least, it is probably time to trim bond positions back to a neutral weighting (I have been overweight bonds for years now). It also probably makes sense to have at least a neutral weighting in stocks for the time being, if we are to assume that the ultimate inflation outcome likely lies somewhere between what the bond market and gold market is predicting.

I am not a financial advisor. These analyses are conducted for personal enjoyment only.

Inflation is not a problem (yet)

I've been saying for a while that the dominant underlying economic force in the United States is that of deflation. If left to its own devices the US economy would collapse into a deflationary depression and take the world economy with it. Of course, the economy has famously NOT been left to its own devices. The federal government has invested $750 billion in the banking system, issued a $700 billion stimulus package AND forecast deficits of 5-10% of GDP as far as the eye can see. The Fed has expanded its balance sheet by $1.25 trillion since the collapse of Lehman Brothers, with plans to expand it even more by buying long term treasury, mortgage and asset-backed debt. The Fed Funds rate has been set at 0% to 0.25%, allowing the banking system to borrow from the Fed at very low short term rates, while risky debt is yielding much higher rates, fattening bank profits (before asset write-downs).

We are in uncharted economic waters, and in a system as complex as the world economy, it is hard to separate signal from noise in terms of what effects our policies will have and how they get transmitted through the economy. In economics class, most rules start with the assumption "all other things being equal", which in the real world is never true. In fact, the economy is in a constant state of disequilibrium, but with a powerful force that seeks to restore equilibrium in some things while creating more disequilibrium in others. In my view, the easiest way to make money is to spot the disequilibrium that faces the path of least resistance to be corrected and to bet on that correction.

The correction occurring right now is the massive unwinding of the inflationary housing bubble. The unwinding of a debt-fuelled inflationary bubble comes in the form of debt deflation. Because an unchecked debt deflation is what caused the Great Depression, today's economists have been taught to fight debt deflation at all costs. Thus we are recapitalizing the banks, printing money like mad and engaging in deficit spending. In other words, we are fighting a deflation specific to real estate (and to a lesser extent, LBOs) with a generalized inflation. The inflationary policies are alarming to many, even prompting a recent round of speculation that the US may lose its "AAA" credit rating. So far, however, market signals are telling us that the greatest set of inflationary policies ever devised has so far only created "reflation", or the undoing of deflation, and are not yet signaling high inflation. The Fed and Congress will need to be vigilant about withdrawing this inflationary stimulus if the market signals do start pointing to inflation, however. The signals I watch are the TIPS spread, the Treasury yield curve, the value of the dollar and the price of gold.

The TIPS spread

The easiest way to look at the market's inflation expectations is with the TIPS spread, or the spread between the yield on a Treasury Inflation Protected Security and a nominal Treasury bond.

As of Memorial Day 2009, the nominal 5-year bond yield is 2.14%, the 10-year is 3.37% and the 30-year is 4.32%. The 5-year TIPS yield is 1.34%, the 10-year is 1.63% and the 30-year is 2.12%. That means the 5-year market inflation assumption is 0.8%, the 10-year assumption is 1.74% and the 30-year is 2.2%. Since the Fed's implicit inflation target is 2% and in historical practice it has been 2.5%, inflation would appear to be well in hand.

However, those numbers assume that inflation averages 0.8% for the next 5 years, jumps to 2.7% for years 5-10, and then settles back down to 2.4% for years 10-30. Not terrible, but probably a pretty good assumption that inflation will accelerate after the eventual recovery.

Treasury Bond Yields

If you assume the Fed has a long term goal of 2% inflation, the equilibrium treasury yield curve would look like a Fed Funds rate of 2.75%, a two-year of 3%, a five-year of 3.5%, a 10-year of 4% and a 30-year of 4.5%. I put a band of 25 basis points (0.25%) around the Fed Funds and the two-year and a 50 basis point (0.5%) band around the 5-30 years, just to account for the fact that this isn't an exact science. (I use 2.75% or the Fed Funds rate, because that leaves a zero percent return after inflation and taxes, which is all you should expect for holding riskless cash.) By this analysis, the Fed Funds rate, the 2-year (at 0.85%) and the 5 year are well below their equilibrium rates, the 10-year is approaching its equilibrium range and the 30-year is in its equilibrium range.

The current yield curve implies that inflation and the Fed Funds rate will be low for several years, but that reflation will be successful but controlled and that is what's being reflected in the 10-year and 30-year spreads.

The Dollar

One problem with using treasury yields for a market indicator is that the short end of the curve is always manipulated by the Fed (and the Fed sometimes gets it wrong) and recently the Fed has even been manipulating the long end of the curve by buying Treasuries. If rates are manipulated too low by the Fed "monetizing" the Federal debt, the pressure would be relieved in the form of a weaker dollar.

When deflation is a problem, people hoard dollars to stay liquid and the dollar rises. In reflation, the dollar is pushed back into its equilibrium trading range. In inflation, the dollar bumps against the bottom of its trading range, as it did as recently as early 2008.

Nominal Major Currencies Index:

The dollar, relative to other major currencies, has been on a mild downward path (less than 1% per year) since we dropped the gold standard in 1973, if we exclude the two dollar bubbles of the mid 1980s and the late 1990s. Given that the original fixed currency values under the gold standard (Bretton Woods dollar standard, really) were set after World War II, when the US had most of the world's gold and the only major economy not devastated by the war, I'd actually say that's not a bad performance for the dollar.

In my view the equilibrium value of the major currency dollar index is between 84 and 70, with a mid-point of 77. It is currently at 79.5. While the dollar has fallen a bit in the last few weeks, it is still near the high end of its range.

Real Broad Dollar Index:

Against all currencies (in real terms), including emerging market currencies, the dollar as of the end of April was at 96, just above its long term equilibrium range of 85-95. Given the action so far in May, it's probably now in the range, but close to the top of the range. This means people are no longer hoarding dollars in a deflationary manner, but it also means inflation is not out of control.

Gold and commodities

Of course nearly every country in the world is printing money and running large deficits to get through this crisis. When all currencies are being inflated, they can all drop together, even while the dollar appears to be in its trading range. When all currencies are weak, the price of gold and other hard commodities rise as investors lose faith in paper assets and move their money to assets that protect the long run value of their hard earned savings. Gold, while it pays no interest, will at least in the long term (since the dawn of man, really) serve as a store of value as long as it's not bought during a speculative fervor.

Gold price in dollars:

The value of the dollar has declined from 1/35th of an ounce of gold during the Depression to around 1/150th of an ounce in the mid 1970s, to an average of about 1/375th from the mid-1980s to the mid-1990s to about 1/900th of an ounce today. That means the dollar today is worth just 3.9% of what it was during the Depression and World War II.

The price of gold rose from $260 an ounce in 2001, when the dollar was strong and real interest rates were high, to $1000 per ounce during the recent inflationary fervor in early 2008. Had severe deflation taken hold, I would have expected gold to fall back to under $600 per ounce. Instead, it has stayed high (generally in the $850 to $950 per ounce range), and it is currently at $955. If gold remains under $1,000 per ounce, renewed inflation (beyond what the market anticipated before the bubble burst) is probably not a problem.

Another way to look at commodities is the value of a commodity relative to gold. The "normal" price of oil, for example, during the 1980s and 1990s, was $20 per barrel. During that period the normal price of gold was $375 per ounce. If the new normal price of gold is $900/oz, the new normal price of oil is $48 per barrel. Today it is at $60…probably overvalued at bit, but not signaling massive inflation.

Conclusion

The market signals are not currently pointing to inflations' being a problem for the US. That said, the Fed must be vigilant about moving rates to equilibrium or above when the signals start pointing to an inflation problem. The signals pointed to inflation in 2004-2008 and the Fed was slow to respond. Now the Federal government is in on the action as well. Congress will need to rein in it spending when the time is right. Unfortunately, Congress' track record has not always been strong in that regard.