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Inflation and Gold Rallies — Not So Fast

20 September 2012 in Trading Ideas

After the Federal Reserve’s move last week to embark upon “QE3” – in this case, a third round of quantitative easing that will involve the central bank’s purchase of mortgage-bank securities – the inflation clock seems to have been set on Wall Street.

Just one day after the Fed’s announcement, market expectations for US inflation over the next 10 years rose to their highest level since May 2006, based on the difference between the so-called break-even rate between nominal and inflation-protected Treasury debt.

And true to form, the rise in inflation expectations leading up to and following the Fed’s announcement has been accompanied by a weaker dollar, and higher oil prices, as investors fear that an unlimited expansion of the Fed’s balance sheet can only boost the risk of higher consumer prices in the future, according to a Financial Times article published Monday.

Then there’s gold, the price of which has completely exploded in the past month, jumping more than 10% since mid-September. The Precious Metals motif, which is weighted more than 88% toward gold stocks, has jumped nearly 17% in the past month.

But are those investing in gold relying on a link with inflation that doesn’t really exist? Blogger Barry Ritholtz recently linked to a note from Merrill Lynch that pokes some holes in the correlation. Specifically, Merrill said, “the link between inflation and gold is very limited.”

Merrill’s research suggested that investors looking for places to hedge against a potential rise in inflation could do better elsewhere. “First, gold is not part of the CPI bundle, so a movement in gold will not impact inflation,” the investment bank said. Secondly, gold has not been  a good predictor of inflation, as prices have been much more volatile than headline inflation.

Finally, with a correlation between gold and inflation on a year-over-year basis of just 0.42 and on a month-over-month basis of 0.11 (where 1.0 represents a perfect correlation), “gold is not a great hedge against inflation.”

According to Merrill (as cited by Ritholtz), investors could be better off owning Treasury Inflation-Protected Securities for protection against rising inflation concerns.

So what should gold investors be watching? According to Adrian Ash in a piece earlier this year at Forbes.com, the key combination is inflation and interest rates. According to Forbes, low or negative real returns on “risk-free” bonds and cash can force cautious savers to turn instead to a “rare, indestructible” home for their money.

Nevertheless, Ash suggests that any signs of inflation in combination with the current low interest rates can eventually lead bond investors to pile into gold, driving up prices even further. So, investors holding gold may ultimately look even smarter in the future – even if their reasoning wasn’t entirely sound.

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Tags: gold, inflation