Thursday, July 7, 2016

Gold and TIPS, joined at the hip

It's rare that the prices of two different asset classes should track each other over the years as well as TIPS and gold have.

The chart above compares the price of 5-yr TIPS (using the inverse of their real yield as a proxy for their price, since bond prices move inversely to their yields) to the price of gold. For almost 10 years they have tracked each other reasonably well. What does this tell us?

TIPS and gold share some qualities, but they are also very different. Gold is a physical asset, TIPS are a unique type of bond; gold pays no interest, while TIPS pay a rate of interest that is determined by the rate of inflation. Both are a type of "safe haven" asset—a port in a storm for investors worried about the future. TIPS are double-risk-free, since they are guaranteed by the US government and they pay a guaranteed real rate of interest if held to maturity. Gold is risk-free in the sense that it doesn't deteriorate over time. TIPS are a direct inflation hedge, since their nominal yield goes up and down in accordance with changes in the rate of inflation. Gold is an indirect inflation hedge, since it tends to maintain its purchasing power over long periods. Gold is also a traditional refuge from undefinable risk—the classic port in a storm, no matter what kind of storm.

Changes in the price of TIPS can reflect changes in the demand for inflation protection; higher TIPS prices are sometimes—but not always—associated with rising inflation expectations. Changes in the price of TIPS can also reflect changes in the market's expectation for real growth (see chart above); TIPS pay a real rate of interest that ultimately is generated by the economy's capacity to grow. Since their introduction in 1997, the real yield on TIPS has tended to track the economy's real rate of growth. So TIPS can tell one of two stories, depending upon how the real yield on TIPS moves relative to the nominal yield on Treasuries of similar maturity. If nominal and real yields rise by the same amount, the message of TIPS is that the market is pricing in stronger growth expectations. But if nominal and real yields diverge, then the message is that the market is pricing in changing inflation expectations.

As the chart above shows, the recent decline in nominal and real yields has been roughly the same. Inflation expectations haven't changed on balance over the past six months. This tells us that the market is pricing in lower growth expectations.

So: since gold prices have risen in line with TIPS prices, does that imply that gold is pricing in weaker growth expectations? That's possible, in the sense that weaker growth increases the likelihood of unpleasant policy surprises. Central banks might over-react to persistently weak growth by easing too much, which in turn would give us unexpectedly high inflation in the future. Politicians might over-react by passing "stimulus" legislation that has little or no ability to actually stimulate, but instead only weakens the economy and perhaps endangers certain sectors of the economy. Think higher taxes to fund more transfer payments, which only end up resulting in less investment. The rise in gold prices could thus be signaling that the economic outlook is becoming uncomfortably "clouded," and thus there is an increase in risk that cannot be hedged by traditional means. Enter gold.

I don't have a definitive answer for all this, but it bears watching closely. At the very least the rise in TIPS and gold prices is telling us that the market is willing to pay a higher premium for protection because people are getting nervous. 10-yr Treasury yields at 1.38% tell us essentially the same thing: there's very little hope for growth, and a lot of concern that whatever happens it won't be stronger growth and could be worse. When the market is paying very high prices for a variety of traditional hedges, you know that people are nervous.

The only anomaly is the Vix index (see chart above), which is only modestly elevated. So the interpretation of all the data is not robust.


William McKibbin said...

The correlation between TIPS and gold is an interesting find, thanks.

Benjamin Cole said...

I have a different take: if you have to pay for the right to own a government bond (Japan, Switzerland, Germany) why not try gold?

It may be that falling bond yields make gold more attractive.

Or it may be the People's Bank of China is buying gold, as they have in past. It is one way to accumulate assets and lower yuan values.

But perhaps gold sends dubious signals. People do not scrutinize silver prices for hidden meanings. Auriferous fever causes dementia!

T J33A said...

Always enjoy you take on things. Thanks.