Recently, a local radio station reported on the rising price of gold, which caught my attention for two reasons. Firstly, small news outlets typically do not report on assets and if so, they preferred to focus on more en vouge assets like Bitcoin or growth stocks. Second, when entertainment programs discuss assets, it's usually a sign to approach that asset class with caution in the near future. While these are my personal subjective observations, they have often proven to be accurate.
However, I would like to make an exception this time, as I believe that we could be in for a significant uprise in hard assets like gold, Bitcoin, and others. Please note that this is not investment advice, but rather my personal opinion/observation based on certain factors that I will further explain. If you have a different view, please let me know and leave a productive comment.
Let`s talk gold - Gold has been an essential currency and a store of value for civilizations throughout history, and it remains relevant in today's modern investing landscape. It`s unique set of properties, such as scarcity, portability, divisibility, durability, and acceptance, make it an important asset to consider. Additionally, all major central banks hold relatively large gold reserves, which highlights its importance as a global payment instrument. Most recently, the PBoC boosted its gold reserves for a fifth straight month, as reported by Bloomberg the other day (although this represents only a small part of their reserves). In the discussion if Bitcoin can serve as “modern gold”, this institutional adoption at the sovereign level is an often overlooked but significant difference between the two.
In addition to serving as a safe-haven asset during crises, adding gold (or Bitcoin) to your investment portfolio can prove beneficial, given its track record of exhibiting minimal correlation with stock market fluctuations. This quality makes it an attractive option for diversification purposes. Further, gold has historically been an excellent hedge against (monetary) inflation, especially during times when the value of a currency is depreciating. Gold's overall performance during or after economic downturns and political uncertainty has also made it an interesting asset for long-term investors. With regards to the likelihood of economic downturns and geopolitical instability, I am of the opinion that both factors are apparent currently.
But let's forget gold for a moment and move to another market. After the stock market ran out of steam last year and is currently moving sideways at best, the more interesting market remains to be the bond market. In particular the deep and usually very liquid market for US Treasuries. The various events of the past year have recently put the functionality of this market to the test on several occasions. While treasury yields usually fluctuate only a few basis points, there have been much stronger ups and downs in recent months. This becomes visible in the MOVE index which is bouncing around on high levels. This is a very obvious indicator, that there is a lot of uncertainty and volatility within this asset class. Since almost every asset is priced on the yield of US Treasuries, the constantly changing yield curve makes the investment process really hard for investors.
While thinking longer-term difficult in this environment, one could try to stay more defensive and try to anticipate the nearer future. One interesting indicator that investors can monitor is the yield of the 2-Year Treasury Note. Changes in shorter yields usually reflect changes in economic conditions, therefore the 2-Year Treasury yield is seen as a barometer of economic health and often anticipates the expected interest rate policy. Currently the 2-Year yield bounces around like crazy but from a historic perspective, the 2-Year Note is an attractive investment when hiking cycles come to an end. When central banks have to cut rates, the price of these notes goes up. If you are wrong and rate cuts don`t happen, they usually carry an attractive yield and have a relatively short duration.
What is also interesting to watch, is the correlation between gold and the yield of the 2-Year Treasury Note, which is usually negative most of the time as shown below. Therefore the 2-Year Note is worth looking at, when you hold some gold (or Bitcoin) in your portfolio. CME Group recently published a great article about that correlation.
Let`s assume we are at the end of the current FED hiking cycle and as it appears, there is a lot of recession talk lately. While many believe that a recession is inevitable because of the 2022 yield curve inversion, historic data suggests that the yield curve usually inverts many month before and reverts at the start of a recession. The reason for that phenomenon is that central banks tend to change interest rate policy once they observe obvious recessionary data within their models. Usually, rate pauses or cuts lead to a significant fall in short-term rates, while longer term yields remain more stable causing the yield curve to steepen again. By cutting interest rates, central banks aim to stimulate economic activity and increase the level of borrowing and spending. However, it is not just rates that matter. Liquidity provided by monetary and/or fiscal authorities is also crucial for re-boosting economic growth.
While the real economy takes some time to process newly created liquidity, the financial economy is less elastic. Within financial markets, an imbalance occurs because the amount of liquidity rises while the amount of assets remains the same (or even falls due to defaults). Typically, the prices of risk-assets fall during the first stage of recessions and after selling off heavily, many of these assets start to look cheap compared to historic values. This stage usually coincides with the easing of financial conditions, which animates experienced investors to pile into risk again. And while many investors are still hurt by big losses in risky assets like equities, liquid and safe assets like gold or long duration treasury bonds become investors preferred choice. This is because hard assets like gold or bitcoin don´t carry economic risk and they are basically priced on the basis of supply and demand. So it is obvious that when there is more money (new liquidity) to buy these assets and still the same amount of hard assets like gold, the price of these assets tend to rise.
I have mentioned that gold has long been considered a reliable protection against inflation. However, during times of high inflation caused by growing economic activity, gold often performs poorly compared to other assets. A reason is that central banks can tighten monetary policy in this phase and limit liquidity for unproductive assets like gold. When central banks are successful in their fight against inflation, they usually hurt growth so much that the economy goes into a recession. However, if central banks fail to bring down inflation going into a recession, they may be forced to switch to an expansionary monetary policy too soon, which usually increases the value of gold through the process described above. Another way policymakers may attempt to stimulate economic growth during a recession is by devaluing the currency and expanding the monetary base, which can benefit real assets like gold denominated in the respective currency. This is when gold serves as an optimal inflation hedge.
In summary, adding hard assets such as gold to your portfolio can be beneficial during times of economic uncertainty. Gold's unique properties, historical performance, and global importance make it a great asset for diversification. Additionally, monitoring correlating datasets like the 2-Year Treasury yield can provide valuable insights to understand the performance of this asset class. However, please keep in mind that these are my personal observations which can be totally wrong.