Is gold ironically losing its shine when inflation is rearing its ugly head?

In these trying times, when inflation has begun to bite the consumers, gold should be reigning supreme. That is what conventional wisdom would say. Gold as a hedge against inflation is a textbook play, except that markets don’t play to the textbooks. Markets play to the momentum. For reasons we will discover later in the section, optically, it looks like that the momentum is not with the yellow metal. How else one would explain the loss of luster in gold in times like these when positive real returns (returns adjusted for inflation) are rarity.

In inflationary times, there is always a rush to risk-off trade to protect returns against inflation. One could count on gold in such struggling times because money moves to gold when investors turn risk-averse.   The current environment is one of the typical risk-off regimes where central banks globally are tightening liquidity to contain the inflation monster. But in this cycle too (as in 2013 cycle), it looks like that the typical pattern is not playing out. Or are we missing something?

First, on the gold performance, some surprising findings:

  • In dollar terms, gold has fallen by over 7% in the trailing twelve months.
  • In Rupee terms, optically it looks like it has delivered positive returns (one year) because of currency fall i.e. near 2%+ returns.
  • Most surprising data point is that gold in dollar terms has remained flat over the last decade. This may not be good news for gold bulls.

One of the main reasons why gold falls (in dollar terms) during Fed tightening cycle is that it is priced in dollars. When dollar becomes dearer, which typically it becomes during the tightening cycle, gold which is priced in dollar moves down. It was no different in 2013 taper cycle. In 2013-2015 taper cycle, when dollar index rallied by over 18%, gold in dollar terms fell by 16%. It was more or less in line with the dollar index rally. But in this cycle, dollar index has rallied by over 17% in the last one year. Gold fell too, but far less than what the dollar index did. What explains the gap this time?

In the last taper cycle, inflation was not such a big worry as it is now. Hence probably gold fell in line with the dynamics of the dollar index. But in this cycle, with inflation out of control, probably there is new money moving into gold which explains the out-performance of gold versus dollar index. Though superficially, at the outset, it looks like that gold prices have fallen in dollar terms, in relative to dollar index rally, it has out-performed. This outperformance couldn’t have happened without some momentum favoring gold. If one goes by this out-performance, conventional wisdom of gold as an inflation hedge does score some winning points. Unfortunately, the out-performance level is not adequate to compensate the rise in inflation (measured in local currencies) across different markets. For e.g., the gold has returned barely 2% returns in India (in local currency) over one year while the inflation is over 7%. From this perspective, one could argue that gold has lost its luster when it comes to inflation hedge. To understand this gap, one needs to understand how momentum works.

In momentum game, rally begets rally in virtuous feedback loop. What performs gets more fuel to perform better.  From this perspective, dollar has attracted more flows because of its stronger immediate past performance. In the competition between dollar and gold in the risk-off flows, the dollar has won hands-down because of the stronger momentum in its favor. Logic doesn’t work when momentum is in play. That explains the unexplainable fall in gold in these turbulent times. Interesting times to watch out for.

Happy Value Investing!!


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