One of the interesting justifications offered up for owning cryptocurrencies like Bitcoin is that they are a safe-haven alternative to the US dollar and the dilutive effects of quantitative easing. The software algorithms, it is argued, are far more restrictive to issuance of new Bitcoins and, therefore, less reckless.  This is fine in theory but, if you really are looking for a safe-haven to protect your wealth from inflation, the fact that Bitcoin can halve in just a few days tells you all you need to know about this particular asset class. The consensus trade can often be the riskiest.

The dramatic rise of crypto currencies over the last decade has been impressive. But their short history and speculative nature means that we don’t have a lot to go on when analysing how they correlate with the other major asset classes. The way in which they interact with real money, how they are taxed for example, is not yet fully developed or understood.

The same cannot be said of the world’s oldest form of money: gold. India is a good example of how gold is owned and used in the modern day. It consumes over 20% of global production and it is estimated that the country holds 10% of the world’s gold which is estimated to be as much as 190,000 tonnes.

The relationship that India’s citizens have with gold is not fully appreciated in the modern context. Gold has been kept by individuals in India for centuries. But, in 1962, the implementation of the Gold Control Act, forbid private ownership of bullion. However, gold manufactured into jewellery was permitted under the act.  In part, this allowance facilitated the giving of largely symbolic gifts of small amounts of gold at weddings and other festive occasions.  In the 1970s, onerous marginal tax rates of 95% made holding gold infinitely preferable to holding or earning rupees in cash. This drove individuals to seek various ways to own gold, at virtually any cost, including the use of black market brokers.

Times have changed, of course, but the memory of the volatility of the Indian Rupee and the affection with which gold is regarded for cultural and security reasons lives on.   And the issue of financial security in India is a serious one.  In the UK, we currently enjoy protection of our bank accounts under the Financial Services Compensation Scheme (FSCS) up to £85,000. In India, it is less than £850.  As a result, it is commonplace, indeed rational, for Indian citizens to hold physical gold until the need arises for cash, which can be obtained through exchange with a money lender. Furthermore, it is also not unusual for businesses or farms to secure financial backing with physical gold. In every way, and in a very modern sense, gold is money.

In the words of John Pierpont Morgan (JP Morgan) himself, in his testimony to Congress in 1912, “Gold is money and everything else is credit”.  This may be so, but how we value gold is a function of the value of everything else and, more importantly, its direction of travel.  One such variable is inflation.

We saw in the first quarter of that year the prospect of rising inflation appeared to be bugging investors more than the effects of Covid pandemic. The narrative was that the unimaginably large stimulus packages must surely be inflationary so the Federal Reserve must be prepared to raise interest rates when inflation inevitably bursts through their 2% target.  Bond yields rose to reflect this, sending bond prices down.  The reaction of the main equity indexes didn’t follow the typical script – they edged higher.  But their rise masked a sector rotation and a recovery in bank stocks which, in the UK, had held back the FTSE relative to its international peers.

Given that gold is often cited as a hedge against inflation, it was slightly surprising that the price of gold didn’t start rising until March. Partly, this was because the Federal Reserve voiced their commitment to keep interest rates low even if inflation starts to run a little hot above their 2% target.

However, the catalyst that sent gold to a 4-month high in mid-May was the rise in the breakeven rate.  This is typically the difference between the US 2-year Treasury yield and a similar Treasury bond with inflation protection attached. This rate moved to the highest level seen since 2008, just before the Great Financial Crisis.

The dovish Federal Reserve comments pushed the US dollar down against most major currencies. But this alone was not the main influence on the price of gold which, of course, is measured in US dollars. Gold priced in Sterling and Euros also rose.

In recent years, we have become used to asset price inflation and investors have been remarkably tolerant of what have been, by any measure, expensively priced stock and bond markets. Partly, this is due to the TINA trade (There Is No Alternative).  Even property, as an asset class, can only hold a tiny fraction of the wealth otherwise tied up in stocks and bonds and it is, of course, generally at the mercy of interest rates in the same way as bonds.

In a world of fiat currencies, equities, bonds and other forms of credit, the price action of gold does appear, even just in the short-term, to be acting as a counterbalance to market volatility.  That is to say, we should not just look at the price of gold in isolation but, rather, relative to the other main asset classes. On that basis, the benefits of owning gold as a portfolio diversifier cannot easily be dismissed.

 

Christopher Saunders Chartered FCSI