TIPS vs Gold: which is the better inflation hedge?

TIPS and gold are widely considered to be classic inflation hedges, but they couldn't be more different. TIPS (Treasury Inflation Protected Securities) look far more attractive than gold these days, since they are not only an inflation hedge but also a deflation hedge and a hedge against an economic slowdown or recession.

Here's how they stack up against each other on key attributes:

Guarantees: Gold promises to keep up with inflation over long periods, but there is no guarantee this will happen, especially over shorter periods. TIPS, on the other hand, are guaranteed by the US government to keep up with inflation—and then some, due to the 2% real yield they currently pay on top of whatever inflation is registered by the CPI. Arguably, TIPS have an additional benefit since they are tied to changes in the CPI, which tends to overstate inflation over time (by about 0.5% per year according to most estimates).

Holding costs: Gold pays no interest and costs money to store. TIPS pay a guaranteed real rate of interest and their principal is adjusted for inflation continuously—and since TIPS are Treasuries, they are default free. Owning TIPS at a typical brokerage firm costs virtually nothing (there several ETFs which invest exclusively in TIPS as well).

Recent price action: The recent bout of high inflation has fueled demand for gold, which has risen about 25% in the past three years. In response to rising inflation, the Fed has tightened monetary policy significantly, boosting 5-yr real yields (the benchmark for most TIPS investments) from a low of -2% to +2.2% in the past two years, thus reducing the price of 5-yr TIPS by about 20%.

Background: The level of real yields is the best measure of how "tight" or "loose" monetary policy is: the higher the tighter, the lower the looser. Tight money is always associated with high real rates, and thus low TIPS prices. You can read detailed explanation of the mechanics of TIPS here. 

And now for some charts:

Chart #1

Gold is expensive. Chart #1 shows the inflation-adjusted price of gold from 1913 through today. Gold was worth about $19/oz back in 1913; in today's dollars that would be about $600/oz as shown in the chart. From an historical perspective, gold is pretty expensive. Today it is only about 20% below its all-time high in today's dollar terms (~$2400/oz in 1980), and it's up some 580% from its all-time low (~$280/oz in 1970). Over the past 110 years, gold in today's dollars has averaged about $780/oz. It'w worth 140% more than that today. 

Chart #2

Chart #3

Real yields tend to track gold prices. As Charts #2 and #3 show, TIPS and gold prices tend to move together—but not all of the time. Chart #2 compares the prices of 5-yr TIPS (using the inverse of their real yield as a proxy for their price) to the prices of gold in today's dollars. Chart #3 uses a shorter time frame and nominal gold prices instead of real gold prices. Chart #2 starts in 1997 because that's when TIPS were first introduced.

The first anomalous period was in the 2000s, when TIPS prices soared and gold lagged but finally caught up. We might say that in this period, real yields were leading indicators of gold prices. The second anomalous period began early last year, as TIPS prices fell (driven down by tighter Fed policy) and gold prices held relatively steady. The question today is: will gold prices eventually fall given the high level of real yields? I think there's a good chance of this happening, especially if the Fed stays too tight for too long. But if not, then we're likely to see real yields fall as the Fed eases, thus driving the two prices closer together.

TIPS are cheap, given the high level of real yields which in turn are driven by tight Fed policy. The Fed is tight because they want inflation to fall. But as I've been pointing out for the past several months, inflation is falling and is very likely to continue to fall; by some measures it's fallen well into the range that should make the Fed happy. The Fed and the market seem to be overlooking this key fact, but sooner or later it will become blindingly obvious that inflation has been tamed. That should prompt the Fed to ease, and real yields to fall, thus boosting TIPS prices.

In summary: Recent high inflation has driven demand for gold to historically high levels. Meanwhile, Fed tightening has pushed real yields sharply higher (and TIPS prices lower). Gold is vulnerable to lots of downside risk in a low and stable inflation environment (such as we're likely entering) and is far more volatile in price than TIPS. TIPS have upside price potential if the Fed eases, and their downside risk is limited by how much the Fed can tighten. If real yields were to rise to 3-4% on top of inflation, TIPS become compelling and relatively safe alternatives to equities. Every time real yields have risen to 3-4% or more, the economy has suffered a recession and the Fed has eventually eased.

Conclusion: Gold is exposed to the threat of high real rates and the likelihood that inflation will soon fall to the Fed's target, if not lower. TIPS are a deflation and recession hedge because either event will force the Fed to ease, thus lowering real rates and boosting TIPS prices. TIPS are an attractive and guaranteed inflation hedge since they offer a government-guaranteed real yield in addition to having their principal continuously adjusted for inflation.