Submitted by
SK
Options Trading
as part of our
contributors program
.
Gold serves numerous functions as an investment. Traditional
reasons for investing in gold include:
Inflation
Investment market declines
Burgeoning national debt
Currency failure
War or other extreme events
Social unrest
Some would argue these entire phenomenon are related. For
instance investment market declines can lead to war which can be
followed by inflation which can lead to currency failure - just
look to Germany in the 1920s for proof of this (albeit in a mixed
order of events).
Basically, gold is protection against various ugly or
undesirable societal, political, economic and financial
occurrences. That reasoning broadly explains gold's rise from $650
in 2007 to approximately $1800 today. Gold has risen over the last
few years on the back of uncertainty and weakness in major global
economies.
But of all the reasons given to invest in gold, the most common
traditionally and the one we hear most often is protection against
inflation. Inflation is often a consequence of increases in the
supply of money that don't coincide with an increase in the output
of goods and services - basically, higher prices as a result of
excess money competing for a fixed number of goods.
Central bankers can print all the FIAT currency they like which
although not always, will generally precede inflation. Gold on the
other hand is essentially fixed in supply and free from this
burden. It cannot be inflated by central banks.
Gold is essentially the ultimate alternative
currency
. It is the currency people head to when their paper currencies are
falling to bits, as we've seen over the past few years.
Let us investigate the relationship between inflation and the
price of gold over the past 50 years to see if inflation really is
the main determinant of the price of gold:
The R2 value of 0.1065 tells us 10.65% of the variation in the
gold price can be described by inflation. Only one tenth of gold's
fluctuations being caused by inflation hardly gives credence to its
status as a good inflation hedge.
If we restrict our timeframe to 30 years, the results are even
more revealing:
The relationship actually turns negative! In times of inflation
over the last 30 years, gold has generally lost value.
Clearly there are other, more important factors at play that
have a greater bearing on the gold price than inflation. One must
also keep in mind that during times of economic boom inflation can
often run at higher levels, but gold will not be sought as an
investment since stocks and other asset classes will be better
performers.
We hypothesise that rather than being an inflation hedge,
gold is better defined as protection against currency
depreciation.
Currency depreciation is defined as a reduction in the value of
one currency with respect to one or more other currencies. This is
relative and speaks nothing of a currency's absolute value.
Measuring currency depreciation via exchange rates does not tell
the whole story.
If for instance, the USD depreciates 20% against the Euro in a
given year it has
depreciated 20% only on a relative basis to the
Euro.
This gives us no information about the USD's absolute value.
Imagine the Federal Reserve doubles the supply of USD tomorrow.
And for whatever reason, the European Central Bank does the same
and doubles the supply of Euros. In very basic supply & demand
economic theory one would expect no change in the EUR/USD exchange
rate and hence if that was the currency pair one used to determine
the value of the USD they would say it was just as strong as it was
yesterday. On a basis relative to the Euro they are correct, but on
an absolute basis the dollar has depreciated significantly as a
consequence of rapid monetary expansion.
The very nature of FIAT currencies necessitates perpetual
increases in the supply of money, at an exponential rate. From day
one, every FIAT currency has gradually depreciated. That is why
goods in the early 20th century cost a fraction of what they do
now, not because they were
cheap
then, but because the dollar was more
valuable
.
This is where the lines between inflation and currency
depreciation are blurred. One could say that over the last 100
years the value of the USD has gradually deteriorated due to
inflation. The flipside of that argument is this "inflation" is
actually inherent in our monetary system and is attributable to the
ever increasing supply of money that is a mathematical necessity
with FIAT currency.
To illustrate the difference between inflation and currency
depreciation we return to the 21stcentury. QE1 was launched in late
2008 as a response to the dire financial and credit market
conditions as a result of the global financial crisis (GFC). QE1
involved the Fed purchasing around $2 trillion in mortgage backed
securities and treasuries. The catch is they did it with newly
created or "printed" money, and hence the money supply rose by
around $2 trillion in little over a year.
Predictably, this reduced the value of the USD as it became far
less scarce.
As we mentioned earlier, to gauge the actual value of a given
currency one
must look past its value relative to another
currency.
The USD index on the above chart measures the
relative value of the USD
against a basket of currencies. When the Fed printed $2 trillion
during QE1 the value of the USD deteriorated almost 8% relative to
other currencies.
Can we say this was an absolute depreciation in the value of the
dollar and not just relative to other currencies? In this specific
scenario, the answer is yes. The GFC emanated in the US and
hammered their economy and financial system harder and earlier than
most. Hence, the Fed had to act before most other central banks
did. Consequently,
the monetary expansion and currency depreciation we're now
very familiar with worldwide began in the US with QE1
. Therefore, the 8% net fall in the value of the USD over QE1 is
indicative of an absolute depreciation in its value.
Now we've established QE1 = expansion of the money supply and
supplementary USD depreciation, we can illustrate the difference
between currency depreciation and inflation.
If currency depreciation and inflation were one and the same
we'd expect a rise in inflation to coincide with QE1 (blue segment
above). That did not occur to the extent many believed it would.
Although inflation increased (from a deflationary environment) it
still stayed low and has done for a significant period of time.
If one had of taken the traditional, one dimensional view that
gold = inflation hedge they would have expected a very low return
from gold over that period. Here's what they would have missed out
on:
Gold rose nearly 50%, coinciding with a 7.84% drop in the USD
index, and all the while inflation remained contained or even
negative.
Those that correctly identified gold's fundamental value as
protection against currency depreciation would have done very well
for themselves during QE1, since,
and going forward
. Those that predicted low inflation and stayed away because gold =
inflation hedge would be kicking themselves.
Those that claim gold = inflation hedge are not absolutely
incorrect.
Generally, inflation and currency depreciation are very
closely linked and correlated.
When one sees a spike in inflation and a corresponding increase in
gold, cause and effect tells them gold = inflation hedge. What is
actually happening is currency depreciation followed by, and
visible in, inflation. Gold then rises with this increase in
inflation. The root cause remains currency depreciation, and
inflation is sometimes the most obvious embodiment of that
phenomenon - so the two can be confused.
We've investigated the relationship between inflation and
various other commodities, indexes and currency pairs. Among the
commodities, corn, silver and copper were even weaker inflation
hedges than gold.
The best inflation hedge we found is crude oil:
The relationship here shown by the R2 value is stronger than
that of the other commodities, but still far from convincing. This
tells us in times of inflation one is better off buying crude oil
futures, or perhaps way out of the money call options on oil, as a
hedge against diminishing purchasing power. This is quite a
sensible conclusion. Crude oil is one of the most common input
costs. In Western economies almost all goods have the cost of oil
implicit in their price. Increasing oil prices cause an inwards
shift of the short run aggregate supply curve, driving cost
inflation.
Since 2007 the US's oil consumption has tailed off somewhat, and
hence oil is less of a determinant of inflation than it once was.
However oil consumption has been tracking up in unison with GDP
growth since 2009. Whether this trend continues is open to
speculation. For the foreseeable future we predict oil will
continue to be a better inflation hedge than gold. If one is
worried about inflation, buy oil.
If one is worried about slowing growth, currency
depreciation, political and financial certainty, unemployment and
war, buy gold.
Gold will generally perform given any of these scenarios. It is a
far more diverse investment than oil which is best in times of
inflation or strong growth. We see neither strong growth nor high
inflation in the coming years.
Gold is essentially the best hedge against loose monetary
policy and active currency depreciation by central
banks.
The Fed's response to lagging growth and persistent unemployment
will be further rounds of QE. QE3 has been launched within the last
month and sets the stage for the Fed to print at least $40 billion
per month for the next three years or more. This means more
monetary expansion and currency depreciation and is likely to send
gold much higher, as it did during QE1 and QE2. To make the most of
this please visit our website and consider subscribing to our
premium options trading service. Our model portfolio has returned
500% since inception just over three years ago.
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the data provided. Nothing contained herein is intended or shall be
deemed to be investment advice, implied or otherwise. This letter
represents our views and replicates trades that we are making but
nothing more than that. Always consult your registered adviser to
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