By Michael A. Gayed
"History has always been a series of pendulum swings, but the individual doesn't have to get caught in that." — Robert Johnson
Remember all those predictions for massive hyperinflation in the past two years? All the headlines that stressed interest rates in the U.S. were set to rise substantially and soon?
My interests lie less in making long-term predictions, but rather in interpreting the message of the markets. In many ways, the only question that matters for investors in whether the bond market is right - whether we are entering a global deflationary cycle or not. The fact that Treasury yields are at panic lows today while equities remain elevated is a significant disconnect to pay attention to. I say this is the only question that matters because deflation in a highly leveraged economy (as most developed nations have) is incredibly painful and difficult to get out of. Ask Japan for proof of that. While the reflation trade is what ultimately led to the October Melt-Up in risk-assets, as I have noted before here on MarketWatch, Italy changed everything. Europe once again is throwing the world into deflation mode.
What does any of this have to do with Gold? One of the reasons investors in the precious metal buy it is because of expectations that the whole world will enter into a period of significant inflation. Gold then acts as a hedge against devaluation. There is some logic to this, particularly when you look at periods under which Gold performs well. Historically, when entering into what's called a negative real rate environment, Gold tends to trend higher. A negative real rate environment means that the rate of inflation is higher than nominal interest rates. Basically, its a moment in time when you don't get compensated in the bank for rising costs surrounding you.
However, if the bond market is right, then we may be entering into a period where we are no longer in a negative real rate environment. If we are headed into deflation, that means the any interest rate which is above 0% results in a positive real rate environment (due to negative inflation). This is not an environment historically Gold can do well. That means that despite arguments that Gold continues to outperform Treasury paper, it could very well be that the pendulum swings to Treasuries outperforming Gold. As an example, take a look below at the price ratio of the iShares Barclays 7-10 Year Treasury Bond ETF IEF +0.20% relative to the SPDR Gold Trust Shares GLD -2.57% . As a reminder, a rising price ratio means the numerator/IEF is outperforming (up more/down less) the denominator/GLD. Focus less on the actual ratio itself and more on the underlying ratio trend.
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First, note that the IEF:GLD price ratio for the past two years has been in a powerful downtrend as Gold significantly outperformed Treasuries following the peak fear post-Lehman of a global seize up in financial markets in late 2008. The period since has effectively been one of significant reflation globally as the Fed sent interest rates to 0 and initiated QE (Quantitative Easing). What I want to point out now is that the ratio bottomed out in mid-August and for all intensive purposes appears to be in the early stages of an uptrend. This would occur under a scenario of long-term deflationary expectations taking hold in the psyche of investors. It looks like we may be entering a period where paper beats rock.
The author, Pension Partners, LLC, and/or its clients may hold positions in securities mentioned in this article at time of writing. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.
