Gold: Inflation Hedge or Not Really?

19 сент. 2022 г.

COMEX: Gold Futures (GC1!)
Last Tuesday, September 13th, the Bureau of Labor Statistics reported that U.S. Consumer Price Index rose 0.1% in August to an annual rate of 8.3%. Both were higher than market expectations of -0.1% and 8.1%, respectively.

One tenth of one percent didn’t seem much, but it refuted the mainstream notion that inflation has already peaked, and the Fed would tone down its tightening policy. The Dow dropped 1200 points on the news. Other US stock market indexes declined 3-4%.

On September 15th, gold price fell sharply. COMEX gold futures (GC) plunged below 1670/oz. It closed down $40, or more than -2%, to its lowest level since April 2020.

Gold price runs like a roller coaster this year. It surged to 22070/OZ after the Russia-Ukraine conflict in February. Since then, it nose-dived as the Fed began raising interest rates. By September 15th, gold price has shaved off 19.3% from its 52-week high.

We have long held a belief that gold is a good hedge against inflation. Now that US inflation runs at a 40-year high, we would have expected gold price to rise and help investors preserve their purchasing power. But why is gold price falling?

In today’s story, we will explore the potential repricing of gold as a financial asset and a precious metal, in a new investment paradigm marked with rising interest rates and high inflation. (For previous writings on the “Great Wall Street Repricing” series, please follow the links at the end of this report.)

What Caused the Gold Sell-off?
Recent price slump is a direct result of investors liquidating their gold positions. As of September 13th, the world’s largest gold ETF fund SPDR Gold Shares saw its open interest falling by 80 tons to 962.88 tons, the lowest level since March.

Last week, CFTC Commitment of Traders Report shows total open interest (OI) of COMEX gold futures as 463,674. This represents a 27% drop from March 8th OI of 638,502.

The declines in gold open interest suggest that investors are taking money out of gold. This contradicts conventional wisdom that gold is a safe-haven asset.

Historically, gold has been used as currency (gold coins), storage of value (gold bars), and luxury jewelry (gold necklaces). Today, I would focus on two attributes: gold as a financial asset (paper gold), and gold as a precious metal commodity (physical gold).

Paper Gold
Gold ETFs, Gold Futures and Gold Options are financial instruments with gold serving as the underlying commodity. Paper gold does not generate income. Furthermore, if the issuer holds gold as collateral, the monthly storage and insurance costs will be passed on to investors. Therefore, paper gold could be a negative yielding financial asset.

In good times, any yield-generating asset would have more appeal than gold. Stock value is based on a company's future earnings. Bond holders receive periodic coupon payments. Commercial real estate produces rent income. Cash could earn interest while being invested in time deposit or money market fund.

In times of war, natural disaster, economic crisis, and political upheaval, many assets could be destroyed. A building could be wrecked, a business ransacked, and a banking system shut down. In the early days of the Russia-Ukraine conflict, panic investors fled to gold, pushing its price sharply above $2000.

Gold also serves as a hedge against inflation. When high inflation eats up real return, fixed income asset will underperform. Countries like Argentina, Turkey and Venezuela have experienced hyperinflation of triple-digits, rendering local currency worthless.

However, things are very different this time. While inflation is at decades-high, US dollar index, a measure of US dollar against a basket of foreign currencies, is at 109, its 20-year high. Inflation has not resulted in a depreciation of US dollar.

Although the stock market has pulled back significantly, it is still well above its pre-Covid level. US employment is strong, and the economy has not yet entered a recession. If investors are still debating when and if recession will be here, they are in no rush to buy gold now.

Lately, investors are underweighting equity and bond. Hot money is flowing out of riskier foreign markets. However, investors may park money in cash for now. Earning 3% in money market plus the potential of dollar appreciation seem like a better choice than gold.

Physical Gold
As a precious metal commodity, gold is priced in US dollars in global market.

In general, commodity prices have an inverse relationship with the value of US dollar. In the past three months, US Dollar Index rose 4.64%, while GSCI Index lost 18.66%.


If you compare dollar index with gold futures directly, the 3-month returns are +4.6% and -8.2%, respectively. Therefore, while viewing gold as a commodity, one should not be surprised to see its price falls as US dollar gains in value.


What’s behind the inverse relationship between US dollar and commodity?
• Foreign buyers need to convert local currency into US dollar to buy commodities
• When their currency depreciates against the dollar, it would cost more local currency to get the same unit of US dollar
• Commodities become more expensive for them, which results in lower demand

Whether gold is used as a storage of value, or luxury jewelry, it is sensitive to price. Strong dollar raises the cost of gold purchases. This put downward pressure on gold price.
As the Fed continues to raise interest rates, foreign currencies would likely depreciate further against the dollar, which would continue to push gold price down.

Any Investment Opportunity with Gold?
As gold price falls to a two-year low, is this a good time to buy gold?

Not necessarily. Gold is not yet a “safe haven” instrument preferred by investors, as we have not yet entered global economic crisis. As a commodity, gold faces downward price pressures as long as the Fed continues to raise rates.

Recall our Event-driven strategy focusing on global crisis

and strangle options trade targeting binary outcomes?

Each Fed rate-setting meeting is a big event that could impact the global financial markets. For the upcoming September 20-21 meeting, I would define the likely outcomes as:
1) Exceed Expectations (Fed raises at least 100 bps); and
2) Meet Expectations (Fed raises 75 bps or less)

Aggressive rate hike would strengthen the dollar, as it becomes a higher yielding currency. A strong dollar leads commodity prices to fall, which includes gold price.

If you consider 100 bps to be the most likely outcome, a Put Option on COMEX Gold Futures (GC) is a good way to express your view.

What if the Fed raises 75 bps? Just like the rate hike in July, avoiding an otherwise more aggressive rate hikes would be perceived as good news by the market participants. Gold price would rise as a result, in my opinion. A Call Option on COMEX Gold Futures is more appropriate in this case.

Personally, I view a rate hike of 75bps vs. 100bps as equally possible in the upcoming FOMC meeting this week. If you hold the same view, you could consider a strangle strategy to buy a call and a put simultaneously.

Buying options cost money. I would consider out-of-the-money strikes to lower cost. I would also pick a contract month 60-90 days ahead. For example, selecting the December contract, the strategy could apply to the November and December rate hikes in addition to the September Fed meeting.

Financial market is extremely volatile this year. Getting an information edge increases your odds of success in managing risk. I suggest leveraging real-time market data for a better gauge of market situation. Tradingview users already have access to delayed data. A Pro user could upgrade to real-time CME market data for only $4 a month, a huge discount at the time of high inflation.

Happy Trading.

Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.