Investor interest in gold has been lukewarm since 2011, when prices peaked at USD 1,900 per ounce before falling nearly 50% over the next few years. In June, however, the market snapped back to attention when gold prices broke through USD 1,350, a key resistance level since 2013, and promptly lifted above USD 1,400. While speculation clearly got ahead of fundamentals early in the decade, gold currently serves as a safe asset in a multi-asset context—similar to bonds, but with different characteristics. Bonds generally offer a positive yield while gold costs money to store, but the tradeoff is that gold offers a store of value against bonds which are at risk of rising inflation or policy mistakes.

As bond yields have continued to ratchet lower on falling inflation expectations, the relative cost of holding gold is declining. This makes it an attractive alternative to bonds that are increasingly exposed to any upside surprise in inflation expectations. As the Federal Reserve (Fed) rejoins the rest of the world with a bias towards easing, and the likelihood of currency wars increases, any currency debasement is logically supportive of gold as the alternative to fiat currencies.

Chart 1: Gold price breaks USD 1,350 level of resistance

Chart 1: Gold price breaks USD 1,350 level of resistance

Source: Bloomberg, June 2019

Among asset classes affected by quantitative easing and various experimental monetary policies, the bond market is perhaps the most obvious reflection of the distortions these policies can create. Buying a negative yield bond seems completely counterintuitive—you are paying someone to lend them money—except for the greater fool theory where one expects that negative yields will turn more negative, making it possible to lock in a capital gain provided that you sell at the right time.

European Central Bank (ECB) Chairman Mario Draghi fueled speculation of further action in a recent speech indicating the ECB’s willingness to ease, if need be, by cutting rates even further into negative territory. Chart 2 below shows the performance of negative yielding bonds versus gold. It is not a surprise that as negative yields become more negative, gold prices rise. This is due both to gold’s cheaper relative carry and because it serves as insurance against the bond market getting the current deflation call wrong.

Chart 2: Gold versus negative yielding global aggregate index

Chart 2: Gold versus negative yielding global aggregate index

Source: Bloomberg, June 2019

The decline in yields has clearly served as an important tailwind for gold, and so it follows that a rise in yields will turn into a headwind. Such a scenario could unfold if, for example, Presidents Trump and Xi agreed to get trade negotiations back on track, which would in turn cause the deflation trade to look overdone. However, while the relative cost of owning gold might rise with bond yields, gold still maintains its property as a store of value if inflation were to return, a situation which would be severely negative for bonds.

Another signpost in this regard is the relative performance of bonds versus gold and how this performance affects the US dollar. When bonds underperform gold, as they have recently, the dollar tends to weaken. This suggests reflation, which in turn serves as a tailwind for gold. While it is difficult to say that the dollar will weaken going forward given its strength earlier this year, if trade negotiations get back on track as the Fed begins to ease, the reflation-on-a-weak-dollar story starts to become more plausible.

Chart 3: US dollar (DXY) follows global bond performance relative to gold

Chart 3: US dollar (DXY) follows global bond performance relative to gold

Source: Bloomberg, June 2019

Fundamentals also appear to be supportive. Central banks have significantly added to their gold reserves beginning in the second quarter of last year, while at the same time holdings of US Treasuries have been in decline. Is confidence in US Treasuries eroding? It certainly could be at the margin, given no end in sight to the runaway deficits.

After nearly a decade of quantitative easing and still only moderate inflation, policymakers and politicians alike are emboldened to take experimental policies to the next level. If the so-called Modern Monetary Theory (MMT) becomes mainstream, monetising wider deficits could become the new normal. Printing prosperity never worked in the past and we suspect it won’t this time either. This makes gold a reasonable alternative safe asset compared to US Treasuries.

Chart 4: Central banks’ quarterly purchases of gold reserves (in tons)

Chart 4: Central banks’ quarterly purchases of gold reserves (in tons)

Source: Bloomberg, June 2019

In the near term, gold could give back some of its outsized gains, most likely driven by a rise in bond yields should trade negotiations get back on track. However, over the longer term, where we could see the return of currency wars with central banks simultaneously easing and perhaps the implementation of MMT, gold still serves as a potent safe asset, particularly if confidence in bonds begins to erode. Central bankers are quietly buying gold over US treasuries, despite years of talking down the metal as an antiquated form of money.

Ultimately, gold is less an investment than it is insurance. In a portfolio context, one is happy to see it do very little because it means the rest of the portfolio is likely performing to expectations. However, for rare developments that weigh heavily on equities and bonds alike, gold remains a sensible hedge.