The Real Yield: A Critical Factor In The Current Climate

Conventional wisdom says that gold prices are a reliable indicator of the prevailing inflation winds. At best, that’s only a half-truth. The relationship between the precious metal and inflation is a two-way street. Yes, gold tends to rise when inflation’s trending higher. The linkage inspires the belief that the commodity’s price rises are driven solely by rising inflation. But gold prices can also increase during periods of disinflation and deflation. The lesson is that the crucial factor for gold prices is the real (inflation-adjusted) interest rate, which ebbs and flows over time.

“Gold can be a hedge against the risks of both more inflation and more deflation because both phenomena entail the prospect of serious trouble for financial assets,” wrote John Makin of the American Enterprise back in 2003:
More recently, Paul Krugman crunches the numbers and reviews the theory on this dual relationship, following in the analytical footsteps of a 1988 paper by Robert Barsky and Larry Summers. The results lead Krugman to say of the current bull market in gold: “it is deeply, deeply wrong to think of rising gold prices when bond yields are low as some kind of symptom of monetary excess.”
Brad DeLong joins the discussion:

Basically, gold pays no dividends or interest. It is thus expensive to hold in your portfolio when real interest rates are high, and cheap to hold it in your portfolio when real interest rates are low. When interest rates are high, you have to be pretty confident that gold is going to rise in price in order to hold it in your portfolio–which means that when interest rates are high you sell gold unless you think the price of gold is low.

But enough talk of theory; let’s review how markets are behaving. Consider gold’s price in recent history relative to the real yield, as represented by the 10-year inflation-indexed Treasury (see chart below). Note how the two have been moving together in a fairly tight range for the last two years or so, which is to say since the financial crisis of late-2008 unleashed havoc on the economy.

Gold and the real yield are forever linked, but the degree can and does vary. When real rates fall to unusually low levels or go negative, there’s a stronger connection between the precious metal and inflation-adjusted interest rates. As of Friday, the real yield on the 10-year inflation-index Treasury was just under zero while the 5-year TIPS was negative to the tune of -0.84%. In fact, the crowd has been pricing the 5-year TIPS yield in sub-zero terrain for the better part of this year.
The stock market also shares an unusually robust relationship with inflation expectations during periods when those expectations are subdued. A recent study (“The Fisher Effect Under Deflationary Expectations”) by David Glasner lays out the connection:

Sharp downturns in asset prices are associated with deflationary expectations when ex ante real interest rates are low. Thus if recessions are associated with falling real interest rates owing to falling profit expectations, and if the expected rate of inflation falls below the possibly negative real rate of interest, monetary attempts to reduce inflation may trigger a crash in asset prices, and, in a highly leveraged economy, precipitate a financial crisis. Second, the key to a recovery in asset prices is to raise inflation expectations above the real rate of interest to induce asset holders to shift out of holding cash into real assets.

Glasner is quick to note that higher inflation isn’t always a solution. “Indeed, the case for inflation depends on a very low, or negative, real rate of interest, an exceptional circumstance.”
It’s safe to say that we’re in one of those exceptional circumstances, or at least we’ve been flirting with it on and off for the past several years, and at the moment the flirtation is on once more.
“It is well known that there is normally little correlation between U.S. inflation expectations and U.S. stock prices,” Scott Sumner wrote earlier this year. After reading Glasner’s paper, Sumner concluded:

There is no way to overstate the importance of [the paper’s] findings. The obvious explanation (and indeed the only explanation I can think of) is that low inflation was not a major problem before mid-2008, but has since become a big problem. Bernanke’s right and the hawks at the Fed are wrong.

And that was in January. The macro outlook at the time was somewhat brighter than it is now. If Sumner’s concern was topical when this year opened, it’s even more pressing now.
It’s obvious these days that the economic recovery is stumbling, perhaps to the point that a new recession is upon us. The possibility of another leg down in the business cycle is particularly alarming at this stage given the high levels of debt that still plague the economy. Indeed, some sectors continue to suffer outright deflation—the residential real estate market comes to mind. For roughly four years in a row, the U.S. House Price Index has been falling, according to the Federal Housing Finance Agency.
Given all this, no one should be surprised to find that the stock market is closely tracking the falling trend in the implied inflation outlook as defined by the yield spread for the nominal 10-year Treasury less its inflation-indexed counterpart. In the present circumstances, it’s unlikely that equities will rally for any length of time until inflation expectations stabilize if not rise.

This is a job for the Federal Reserve, of course. Fed chairman Bernanke noted in a speech last week that the central bank still has “a range of tools that could be used to provide additional monetary stimulus.” Alas, the political pressures for austerity threaten to minimize the efficacy of any policy response. Passive tightening, as a result, reigns supreme, both here and in Europe. Greece just unveiled yet another round of fiscal tightening, there’s new pressure on Ireland to do the same, and the entire euro edifice continues to reel from the weight of debt and ill-advised policy responses. In short, “Europe is again on the precipice,” warns Barry Eichengreen, an economist at University of California, Berkeley and author of Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System.
“Despite the ongoing spate of bad economic news in both the Eurozone and the United States, monetary authorities in both places have decided to do nothing new for now,” complains David Beckworth.
Money demand, in other words, is still too high and appears to be rising… again and so central banks need to respond… still.
Meantime, we shall reap what we sow. “In the present context, Treasury bills (or more broadly, short-term government guaranteed instruments) are like gold,” according to Zoltan Pozsar of the IMF.

Just as in the 1960s there were too many dollars relative to U.S. gold reserves, today there is too much demand for safe, short-term and liquid instruments relative to the volume of (i) short-term, government guaranteed instruments; (ii) high-quality collateral to “manufacture” alternatives to short-term, government guaranteed instruments (see Bernanke (2011)); and (iii) capital to support the safety, short maturity and liquidity of such alternatives (see Acharya and Schnabl (2009)).

Citing the quote above, FT Alphaville observes: “It’s for this reason gold does equally well in deflation as it does in inflation.”