Gold prices dropped on Friday, marking yet another price reversal for the precious metal this year. Gold futures were on track for their first back-to-back loss in more than two weeks. Meanwhile, the U.S. dollar strengthened, and Treasury yields gained as economists discussed concerns about inflation. Expectations for inflation are now at their highest level in years, and even though gold prices are usually inversely correlated with inflation, one expert is talking about gold as an inflation hedge.
Inflation expectations now at three-year high in bond market
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CFRA investment strategist Lindsey Bell said in a note this week that the core CPI reading surpassed 2% for the first time on one year last month, coming in at 2.1%. Data from Tradeweb pegs inflation expectations at 2.19%, based on ten-year Treasury inflation-protected securities. That’s the highest level in more than three years, and with all the commentary about inflation that’s circulating right now, it’s easy to see why the bond market is pricing in such high expectations for inflation.
Fed Chairman Jerome Powell warned during a speech recently that inflation could increase to uncomfortable levels if it takes them too long to raise interest rates, but he’s not the only one issuing such dire warnings. Additionally, Deutsche Bank economist Torsten Slok told CNBC earlier this week that inflation presents a huge risk to the markets.
JPMorgan Chase Chief Executive Jamie Dimon told shareholders in his April letter that he thinks many people are underestimating the possibility that the Fed will have to hike interest rates more quickly than expected. At this time, the fed fund futures market is still pricing in a 40% chance of three more rate hikes this year, according to MarketWatch, even though the consensus still calls for only two more hikes.
Gold as an inflation hedge
While many see Treasury-inflation protected securities as a strong hedge against a sudden surge in inflation, Bell highlighted gold as an inflation hedge in her note this week. She explained that the forward breakeven rate for inflation suggests that the market expects a 2.2% rate of inflation over the next give years. Meanwhile, data from Action Economics pegs inflation at 2.1% this year and 2.3% next. As a result, Bell warned that if inflation does end up moving higher than expected in the coming years, investors could be caught by surprise, which would then offer an opportunity to buy gold.
She explained that during time when interest rates are rising slower than inflation, real government bond yields tend to fall or turn negative. In such a scenario, gold prices can skyrocket, which is why she likes gold as an inflation hedge. She also emphasized gold’s ability to store value for investors over the long term, which she said becomes especially important in light of the increase in the national debt that’s expected to result from the spending bill that was passed in March.
Here’s why the Fed may not be able to hike rates fast
Despite the many warnings about the Fed having to raise interest rates faster than expected, Bell said that the macroeconomic environment could restrict the central bank’s ability to raise rates. The budget deficit is expected to surpass $1 trillion by 2020, while debt-service costs rise and increased borrowing is needed to fund the spending bill.
She explained the Fed must handle inflation “in a careful and prudent way under these circumstances, potentially making it difficult to raise rates quickly.” She added that this situation presents an opportunity for gold prices to flourish.
Bell also noted that some might see gold as overvalued, but she disagrees, comparing the rise in gold prices to the increase in the S&P 500. Looking back to 1971, she said the median relative price of stocks against gold was at 1.17, making the S&P worth 17% more than gold. She attributes the momentum in the stock market since 2012 to the easy money policies enacted by central banks around the world. Even though the preference for stocks is down a bit from where it was in December, they are still preferred over gold, she added. Further, even though the stock market has gotten very volatile this year, investors still prefer stocks over gold.
Based on her calculations of the relative valuation of these two assets, gold is approximately 80 basis points cheaper than stocks, so she doesn’t see gold as being overvalued at current levels. Thus, Bell sees gold as an inflation hedge and “a smart and defensive way to diversify a portfolio in the later innings of a bull market.”
CFRA isn’t the only firm singing the praises of gold right now. Goldman Sachs and DoubleLine Capital CEO Jeff Gundlach also revealed that they’re quite bullish on the precious metal. Gundlach went so far as to suggest that gold prices could go up by as much as $1,000. Goldman is bullish on commodities in general, saying that there’s “rarely” been a stronger case to own them.