Gold hits an all time high while stocks and bonds rally in unison. Market watchers will know that the gold market, the stock markets, and the bond markets all tell different stories. You cannot have them all rise in unison; Something’s got to give.
You know if you’ve read this blog for any period of time that I am firmly in the deflation camp for the next few years….at least here in Canada. Much of the inflation/hyper inflation talk revolves around the US. As they are further along in their debt-deleveraging cycle and are stepping on the gas pedal with more force than we are, they may experience inflationary pressures in the next few years. But not here in Canada where our debt-deleveraging cycle is just starting.
BMO cut their benchmark 5 year mortgage rate by 0.1% today amid falling bond yields. To understand why this is happening, you have to know how mortgages are financed. Variable rate mortgages are based on the overnight rate from the bank of Canada plus a spread. This is known as the prime rate. Fixed rate mortgages on the other hand are funded by borrowing money from investors. These investors use an equivalent Government of Canada bond as a guideline when considering what sort of interest rate to demand. Therefore, 5 year fixed rate mortgages are based on the yield of the 5 year government of Canada bond, plus a spread.
As we’ve discussed before, bond investors demand more of a premium to compensate for inflation risk. When the risk of inflation is high, they demand more of an interest rate to compensate for the fact that they are being repaid five years later in dollars that have lost purchasing power. So, what does it tell you about future inflationary pressures when bond yields are at historic lows? Yup…no inflationary pressures to be seen. And remember that the bond market is roughly 15 times larger than the stock market and run overwhelmingly by trained, sophisticated investors. While the stock market signals a return to party times, the bond market is signaling caution. Which will you listen to?
In addition, as the US Fed mulls another round of Quantitative Easing, ask yourself why they would do that if there were any inflationary pressures building. Quantitative easing is meant to stimulate the economy by purchasing government bonds, driving down yields and making money cheaper to borrow across the economy. Why in the world would they be doing this and risking complete destruction of the dollar down the road unless they were completely terrified by the prospects of deflationary pressures ravaging their already weak economy. It’s not inflation or the destruction of currency that keeps Helicopter Ben up at night.
Now remember that inflation is a monetary phenomenon associated with an expansion in the aggregate money supply. You may be inclined to point out rising commodity prices as a sign of inflationary pressure. First, let’s recall that most commodities are still well below their 2008 highs, particularly when priced in Canadian dollars. The most obvious example of rising commodity prices is in the agricultural commodity markets, where the price of many grain products has been rising like crazy.
Is this inflation? This is where we need to be careful how we define the term. If you adhere to the standard definition of inflation as the rise in the Consumer Price Index, then yes it would constitute inflation. But I hold to Milton Friedman’s view that inflation is “always and everywhere a monetary phenomenon”.
With rising agricultural commodities, the culprit here is two-fold: Lower than expected yield meaning less supply, and accompanying new export bans and quotas. It is not a reflection of a rising monetary supply relative to available goods. So if you’re hoping for inflationary pressures to increase house prices and make repayment of debt less burdensome, it’s not going to happen. It’s not that type of inflation.
Interestingly, the Globe ran a piece about deflation and gold prices:
I could not disagree with the author more. Most people believe that gold acts as a hedge against inflation….and at times it does. But what you have to remember is that gold prices act either as a commodity or as a currency depending on the prevailing sentiment of its buyers. When gold is being traded as a commodity, yes its value will rise with inflationary pressures, as all commodities do. But when it is being viewed as an alternate currency, the price movement in gold is altogether different.
It’s my belief that gold is primarily being purchased as a means to hedge against instability in currencies. It explains why central banks have gone from being net sellers of gold over the past 20 years to being net purchasers in the past couple.
Now if gold is increasingly being viewed as an alternate currency, gold prices will rise during times of deflationary pressure as the purchasing power of all currencies appreciates. It also rises during times of deflationary pressures since deflation ravages tax revenues of governments and makes debt repayment more burdensome. Thus, deflationary periods are also times of economic and social instability. Look at the crippling strikes in France and Greece as examples.
So what is the future of gold and silver (another alternate currency)? I have little doubt that it is overbought in the short term and due for a correction. But the general price trend is intact overall. The absolute worst thing for gold would be for governments to actually do the right thing and try to restore fiscal integrity. With the US mulling QE 2.0, it’s not likely that mentality will be embraced in the Western world any time soon.
I’ll continue to add to my gold and silver positions on the drops. Let me reiterate that I agree that inflation will someday take hold in Canada and the US, likely causing a panic rush to purchase hard assets like gold, but I believe that day is still well in the future as the massive debt overhang in the entire Western world must be dealt with first.