Mizuho chart speak – Why gold is not an unqualified inflation hedge

By Vishnu Varathan, Head, Economics & Strategy, Asia & Oceania Treasury Department, Mizuho Bank, Ltd.,

Why Gold is Not an Unqualified Inflation Hedge

“It is a capital mistake to theorize before one has data. Insensibly one begins to twist the facts to suit theories, instead of theories to suit facts.” – Sherlock Holmes, “A Scandal in Bohemia”

Gold’s Not an Unqualified Inflation Hedge

The temptation to declare Gold an inflation hedge that is positively correlated to inflation expectations, in the context of recent run up towards $1900/oz coinciding rising inflationary pressures/expectations (Chart 1), is admittedly not inaccurate. But it is a grossly incomplete characterization. Point being, it lacks critical nuance that Gold is not an unqualified inflation hedge. Specifically, that Gold’s stellar record as hedge against fiat value erosion is superseded only by its vulnerability to rising real yields (Chart 2; Gold more negatively correlated to real yields).

A Solid Fiat Hedge

To be absolutely clear, the broad concept of (Gold’s) inflation hedge rests on its so-called “real asset'” property that resists erosion of purchasing power that tend to afflict fiat currencies. Put different, the proposition is that Gold’s inflation hedge allure derives from its ability to retain value against fiat currencies; consistent with Milton Friedman’s famous declaration that “inflation is always and everywhere a monetary phenomenon”.

Specifically, Gold’s rigid supply, virtually free of potential for manipulation by any monetary or economic agent, presents itself as a far more reliable store of purchasing power. Especially as is characteristics of homogeneity, fungibility, durability and liquidity (market) renders it a close substitute, hence highly desirable hedge for fiat.

… But Falters on Rising Yields

But this snapshot of Gold-inflation dynamics is a gaping blind-spot in stress-testing Gold as an inflation hedge; for it overlooks Gold’s overarching vulnerability to rising yields, as a zero/negative yielding asset, from policy normalisation in response to inflation. In other words, Gold’s inflation hedge is prone to falter on rising yields, which may be expected on policy response to inflation.

Upshot being, while Gold’s ability to hedge against fiat exposures to inflation may be valid, but it nevertheless subordinated to potentially overarching weaknesses to rising rates/yields; in particular if nominal yields outpace inflation expectations (leading to a rise in real yields). Turns out, depending on real yields (flowing from policy), Gold may flourish or falter in the face of inflation.

Credit: Mizuho Bank Ltd