Friday, June 11, 2010

A Puzzle: Gold And T-Bonds Both Rising

As explored by Mark Gongloff in "Unusual Pair: Investors Buy Gold but Also U.S. Bonds," that pair present a puzzle. Both have been rising in the recent turmoil. Moreover, both Treasuries and gold have risen much more than the U.S. stock market in the past decade. Someone buying both long-term Treasuries and gold in 2000, so that each hedged the other, would find that both components of that pair trade rose more then 100% in the subsequent decade. Both are now expensive.

To someone who sees gold primarily as an inflation hedge, that concurrence is puzzling. Depending on how post-crisis inflation turns out, one should be rising and the other falling. Instead, both are rising now. Should inflation come back, T-bonds will likely get slaughtered as they were in the 1970s. Should a deflationary financial 2008-style crisis re-emerge, gold would be hit hard as it was in '08. The square can be circled by concluding that both are crisis hedges.

There's another explanantion, although it doesn't gibe with current economic theory. T-bond bulls are deflationists, expecting a Japan-style scenario, while gold bulls are inflationists who expect a return of the '70s. Since no-one knows the future, either scenario could transpire - or neither, through inflationary and deflationary tendencies cancelling each other out. Both asset classes have risen while the stock averages haven't, and their continued rise suggests more malaise in store for U.S. stocks.

One other factor that ties the two together: gold tends to rise when real interest rates are low, and is almost sure to rise when real rates are negative. There was a burst of inflation in '07 that drove CPI-adjusted real rates negative for a time, and the much-fabled bond vigilantes were largely asleep at the switch. They really were back then.

So, the edge may be with the inflationists - even if gold bulls could be chided for overreacting to perceived inflation portents. Whatever the outcome, the current divide evinces a lot of uncertainty nowadays. The system is loose from its moorings, from the bands of predictability that makes rational expectations work.


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