Hedging Against Inflation, Disaster & the Federal Reserve

Posted on July 15, 2022

By Paul Vanguard, for BullionMax.com As this Forbes analysis tells us, there are two main reasons to invest in commodities: inflation and portfolio diversification. What do we know about gold? It's the best hedge available, probably the asset most uncorrelated to any other. We also know that gold hasn’t been performing well so far this year, with some analysts saying that precious metals are yet to catch up to a broader commodity supercycle. Side note: a “commodity supercycle” is an extended period where overall commodity prices generally run well above their long-term trend. Commodity supercycles can be triggered by broad demand shocks and subsequently lagging supply responses. They tend to last much longer than typical business cycles, about six to ten years. What about the inflation part? Inflation is about the only thing the U.S. has plenty of right now! (Okay, inflation and debt.) Well, most of why gold has been pulling back has to do with – wait for it – rising inflation, believe it or not. Well, actually, the Fed’s response to it. In an effort to rein in 40-year inflation surges, the Federal Reserve started off what many are calling a “very aggressive” interest rate hiking schedule. In reality the Fed’s efforts so far have looked more like trying to lasso a bucking bronco with dental floss and wishful thinking. Oh, and talk – the Fed’s mouthpieces are talking a good game, too! Telling us to expect “pain” because they’re “resolved” to “stay the course” and so on. Pro tip: last time inflation was this high, the Effective Fed Funds Rate (EFFR) started out at 10% -- and Paul Volcker had to raise itall the way up to 20% before finally getting inflation under control. See what I mean about bucking broncos and dental floss? So, back to gold: the thing you have to remember is, gold doesn’t offer a yield. As Warren Buffet famously called gold an “unproductive asset” (to be fair, he compared gold to farmland and Exxon – both potentially productive enterprises with track records of success, something the U.S. government simply cannot claim). When faced with a choice between buying gold and buying U.S. debt in the form of Treasury bonds and bills, global investors often prefer the paper. Why? Because it makes more paper. Your 10-year Treasury today yields 2.93% -- so in 10 years, you’ll get back a little more than you put in. Compare this to gold, where you don’t have any guaranteed return. Rather, when you buy an American gold eagle, what do you get when you sell it? You get one ounce of gold’s number of dollars. By the way, that’s the core benefit and primary reason people buy gold. They’re more concerned with the return of their investment than the return on their investment. (They also tend to be skeptical about the actual value of the “more paper” produced by paper-based investments.) With me so far? Okay. Since the Fed are determined to lasso that wild horse, their big talk has actually convinced some people they can do it. So an awful lot of money has come flooding into the paper debt market – and that causes the “strength” of the dollar (compared to other currencies) to rise. A stronger dollar makes gold’s price go down. Also, for big institutional investors who move billions of dollars around with their keyboards, paper markets are more liquid. So, even though gold almost universally outperforms during rate hiking cycles, the world’s investors have voted with their dollars – and right now, they prefer paper. I say, let ‘em have it. Meantime, I’ll use my stronger dollars to buy more gold.

Maybe dental floss and wishful thinking won’t be enough?

June's inflation reading returned 9.1%, rising against the previous month once again and hitting yet another 40-year high. Yes, “peak inflation” was supposed to have passed in May… and in April, too. (Remember “transitory”?) While the U.S. dollar retains some strength, which is virtually the only thing keeping gold back, even Treasury yields have slipped. Analysts like City Index's Fawad Razaqzada say investors now believe that the Fed might not only stop its rate hiking cycle, but actually return to money printing as early as Q1 2023. You heard that right: even though quantitative easing is what brought on this hiking cycle and the subsequent recession, Wall Street types are already predicting the Fed will surrender the fight against inflation. They’ll put away the dental floss and let the horse run wild. Maybe they will? It’s not as though they’ve given up on MMT which teaches The best way to solve a problem caused by too much debt is to increase debt. Honestly, it’s not like they’re going to be able to get inflation under control – at the rate they’re going so far, the sun will go supernova and wipe out all life on the planet before interest rates hit Volcker-era levels. We know that merely not hiking anymore would have paved the way for gold prices to explode. But actually printing more money? That sounds like the kind of inflation not even gold investors want to talk about. That's one of the benefits of owning physical gold. Panic selling doesn’t affect you (as long as you don’t panic), and gold’s day-to-day prices? You can ignore them! Prices only matter when you’re buying or selling. Speculators might have freaked out over gold going from $1,840 to $1,740, but I don't imagine there are many of us selling our gold Canadian maple leaf coins over it. On the flip side, when inflation does hit, physical gold is the only thing you can trust. Definitely, we seem to be flirting with the idea of hyperinflation, and with it comes economic havoc. Does anyone trust paper gold to protect their wealth during times like these? (After all, one of the ways funds generally cover their costs is by selling their bullion. Talk about a losing proposition!) One of the most important things for bullion investors to understand is that they, so long as they're buying from a low-premium dealer like us, get none of gold's woes but all of its perks. They don't really suffer during price drops like over the past year. A 10% drop in the short-term is of no significance to the bullion owner – because price only matters when you’re buying or selling. In between, it’s just noise. When the "primary investment reason" of high inflation hits, though, the benefits are all there. Gold appreciates over time generally, but it blows up during times of ridiculous Fed policy tinkering like the one we're seeing right now. In times like these, bullion owners might sell a little to get some ready cash. But for the most part, they're just content with not having to watch their wealth destroyed like everyone else.   Paul Vanguard is a lifelong precious metals enthusiast and a proud member of the BullionMax team.