Welcome back. Except for the pair of cufflinks my father gave me, I don’t have gold. My wedding ring is platinum. But this topic is inevitable, especially when the topic everyone thinks of is inflation. So that’s it.

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What is the hedge, what exactly is it?

Wednesday sheet Japan in the 1980s was in a sense about regime change. The thinking at the time was that major changes in Japan’s monetary policy, fiscal methods, and corporate culture brought about asset price bubbles and permanently reset various economic relations. The question is, does the simultaneous introduction of loose fiscal and monetary policies and the change in the Fed’s attitude towards inflation mean that the United States is moving toward a similar regime change?

Since the main risk of this potential regime change is generally believed to be high inflation-which may lead to adjustments in the stock and bond markets-my thinking turned to hedging. Readers have the same idea: I have received many e-mails asking where the safe assets are.

Gold is an obvious candidate. It is often touted as an inflation hedge. But this is too general. Gold has one of the most stable relationships with the economic fundamentals of any asset. It is very regularly inversely proportional to the real interest rate, especially in recent years (all chart data from the Federal Reserve):

The inflation-protected 10-year U.S. Treasury bond yield (blue line) is the standard proxy for real interest rates or inflation-adjusted currency costs and is currently negative.

For 15 years, gold (yellow line, note that the scale is inverted) has been following the real interest rate, rising as the real interest rate falls, and falling when the real interest rate rises. The reason is simple: the real monetary return is the opportunity cost of holding gold, which is an asset with no return. Nominal interest rates have been rising recently, almost entirely driven by inflation expectations, so gold has embarked on an unbalanced but basically sideways path in recent months.

From the chart above, holding gold is not good for you. If the new economic system increases inflation, it can also stimulate real economic activity and real interest rates. In order for gold to work, you must get inflation without any real growth return (even without real economic growth, in the sense of reducing sovereign and household debt burdens, you may have economic returns, but isn’t that? Fans of monetary/financial coordination tend to claim what they are after).

However, I want to know whether the significantly higher and more volatile inflation will make gold more valuable as a hedging tool even if real interest rates rise. High real interest rates that feel unstable may make investors want something stable, don’t they?

The chart below shows the long-term relationship between gold and real interest rates. However, I used a different real interest rate proxy here because Treasury inflation-protected securities is a relatively new phenomenon. Instead, I used the 10-year rate of return minus the annual rate of CPI inflation. This makes a slightly unstable series, but checking against Tips shows a very good match. I also keep the inflation rate in (grey).

The most interesting period here was the 1970s, when two large increases in inflation led to a sharp drop in real interest rates. Zoom in on those years:

What is striking here is that this relationship is established (real yields fall, gold rises), but it is not very stable. When the real rate of return plummeted for the first time between September 1972 and December 1974, falling more than 8 percentage points, gold rose by 179%, which was a very good return during the period when stock values ??fell by one-third. But when inflation appeared for the second time, between 1978 and 1980, gold performed well. In the case of a significantly smaller decline in the actual rate of return, it rose by 238%.

My initial explanation is that as inflationary instability persists, investors’ views on gold are getting better and better, which makes investors more and more anxious.

But then came the 1980s and Paul Volcker’s Federal Reserve. Inflation looks like it has been put back into the bottle forever. Under stable inflation, the real interest rate relationship of gold has been weakened to a certain extent. Between 1985 and 1990, real interest rates fell sharply by more than 6 percentage points, but it occurred in a gradual and orderly manner against the background of relatively moderate inflation and inflation fluctuations. Gold only rose by 25%. Again, the violence of the times and the feelings of investors seem to be very important to gold-not just the actual rate of return.

Of course, the next big rise in gold will occur before and after the great financial crisis. This is a period of various fluctuations.

As real students of metal have now determined, I am not a gold bug. My humble suggestion is that the link to the actual rate of return is long-lasting, but the intensity will vary over time. Changes in the economic system, such as the changes many people are now experiencing, may again change the gold/real interest rate relationship that has seemed so consistent in recent years. Hedge carefully, friends.

Japanese flashback

On Wednesday, I received several e-mails about my articles in Japan from readers who worked in the Japanese financial industry in the late 1980s. Many people commented that today’s environment reminds them of that era. The following is a particularly representative sample from James Bogin, who worked as an analyst in Tokyo in 1987:

“The oil crisis of the 1970s hit Japan more severely than most countries. Their currency was weak, and their oil imports accounted for 10% or more of GDP. Their long-term implementation of a very loose monetary policy led to a stock market boom in potential asset stocks. .. With a lot of liquidity flowing… The company will issue stock convertible bonds with warrant sweeteners because the interest rate is too low. I once asked a cement company why it raised funds, and the answer was basically because of it. Cheap, and we can.”

Discovering new reasons for valuing companies at higher valuations (“potential assets”) is something familiar to the bull market. The proliferation of tricky tools (warrants, SPACs) is the same. What reminds me especially of today is that the company raises funds “because it is cheap and we can”. Hello, AMC.

A good book

I ran into This Wednesday, as early as 2018. It made me feel very real, and I laughed out loud. What are the key characteristics of employees who are emerging in the fields of law, finance, consulting, etc.? This may be personal insecurity.