Gold as an Inflation Hedge? Myth Busted!
COMEX: Micro Gold Futures (
MGC1!) and Gold Options (GC1!)
Gold is often hailed as an effective hedge against inflation. It generally increases in value as the purchasing power of the US dollar declines over time. Does this still remain true? Since January 2013, the US Consumer Price Index increased 29.4% cumulatively, while the 10-year total return of Gold is only 11.3%.
Let’s demystify the gold myth. In fact, gold is by no means among the best-performing investment assets in the past decade! Let’s look at where investing $10,000 in different assets would take you in the past ten years:
• If you held $10,000 in cash, you still have $10,000, a 0% nominal return;
• If you bought a gold ETF fund, you would have $11,300, assuming it tracks gold price perfectly. However, after subtracting an average 0.5% a year in fund expense, you would end up with only $10,800, an annual return of merely 0.78%;
• 5-year bank certificate of deposit (CD) yielded 1.0%/APR in 2013 and 1.5% in 2018. If you put the money in CDs back-to-back, you would have $11,322 now;
• If you invest in a market index stock portfolio, the S&P 500 gained 159% in the past ten years. You would end up with $25,900;
• If you bought bitcoin at $4.43 each in January 2013, you would have amassed nearly $1.6 million from the original 10K, an astonishing 15943% return!
Actual data shows that holding gold, a non-yielding asset, underperformed other investable assets in the past decade.
Gold price endured a double-digit decline, from $1,600 per troy ounce, to as low as $1,000, during the low-inflation period of 2013-2018. It shot up in 2019 as the US-China trade conflict intensified. The outbreak of Covid pandemic pushed gold to a record high of $2,075 in August 2020. As US economy remerged from Covid in 2021, gold price fell back to $1,700. Then, the Russia-Ukraine conflict pushed it back up above $1,900.
However, when the Federal Reserve embarked on the path of rate increases, gold price fell sharply to $1,600. This was a period where US CPI raged between 7-9%, and gold completely failed as a defense against inflation.
US Dollar Is the Primary Price Driver
Gold prices rose on Friday as a rally in the dollar and bond yields paused. COMEX Gold Futures (GC) for April delivery closed up $14.10 to $1,854.60 per ounce.
The rise comes on expectations that higher interest rates are on the way as reports show that US economy is still running too hot to quell high inflation. Dollar index was down 0.35 points to 104.68, while the US 10-year note was paying 3.977%, down 8.4 basis points.
US dollar continues to call the shot for gold as investors assess the Fed's rate path. The above chart shows a perfect negative correlation between gold price and dollar index. When dollar rises, gold falls; and when dollar declines, gold advances.
Last month, the dollar's bounce had weighed heavily on gold. The dollar rallied as a run of hot U.S. labor and inflation data saw traders’ expectations for more aggressive Fed rate increases. A stronger dollar can be a drag on commodities priced in dollar, making them more expensive to users of other currencies.
In recent weeks, gold may have found some support on fears that an aggressive Fed could push the U.S. economy into recession, but a continued rise in U.S. Treasury yields, along with a relatively resilient dollar means limited upside . Rising Treasury yields raise the opportunity cost of holding non-yielding assets, like gold.
Short-term Trading Strategies
At $1,850, gold is neither too expensive nor too cheap by historical standard. As such, I am not in favor of an outright directional trade, one way or the other.
However, the market’s razor-thin focus on Fed rate actions will make a compelling reason for event-driven trades on Gold Futures and Gold Options.
March is a very active month for macro-economic data releases:
• March 8th, Fed Chair Powell will testify on the central bank's semi-annual monetary policy report to the House Financial Services Committee;
• March 10th, Bureau of Labor Statistics will release February employment report;
• March 14th, BLS will release the February CPI report;
• March 22nd, Fed will announce its interest rate decision.
Financial market tends to be sensitive to these data releases, as the latter could deliver huge shocks if actual data goes beyond market expectations.
If you expect an upcoming data release to be bullish on gold, you could express this view with a long futures position on COMEX Micro Gold Futures (MGC).
Each MGC contract has a notional value of 10 troy ounces. At $1,880, a June 2023 contract (MGCM3) is valued at $18,800. Initiating a long or short position requires a margin of $740. This is approximately 4% of contract notional value. In comparison, buying physical gold (i.e., gold bar or gold coin) and gold ETF fund requires 100% upfront investment.
If gold price moves up to $1,950, the futures account would gain $700. Relative to the initial margin, this would equate to a return of +94.6%, excluding commissions.
Alternatively, the same bullish view could be expressed by a call option of COMEX Gold Futures. Each COMEX Gold Future contract has a notional value of 100 troy ounces. At $1,880, a June futures contract (GCM3) is valued at $188,000. A call option on the 1,900 strike is quoted 37.0 on 3 March 2023. Acquiring 1 option requires an upfront premium of $3,700 (100 ounces per contract). If gold moves up to $1,950, the options account would be credited by $5,000 (=(1950-1900) x100), which represents a theoretical return of +35.1% from the original investment of $3,700.
If you are bearish on gold, a short MGC futures or a put option on GC would be appropriate. Futures and options account would gain in value if the price of gold falls.
Similar to investing in physical gold or gold ETFs, the biggest investment risk is betting the wrong direction. However, futures have a built-in leverage. In the case of MGC, each $1 movement in gold price translate into $10 variance in futures account balance. Options have a non-linear payout diagram. As the contract moves deeper in-the-money, options value grows exponentially.
Long-term Trading Ideas
After the active central bank action period is over, will gold price trend up or down? What would be the primary driver of gold price? Inflation, US dollar, interest rate, economic growth, or geopolitical crisis? All are possible, maybe a little bit of each.
My research reveals that gold price has a relatively stable relationship with WTI crude oil (CL). Over the past ten years, each 1,000 barrels of WTI (1 CL) sell at a price between 150 and 300 ounces of gold for about 80% of the time.
We could visualize an oil producer wanting to be paid by gold. When dollar fluctuates, he would adjust the dollar selling price to keep his gold acquisition stable. Therefore, whenever the price range is breached, gold price has a strong tendency of falling back in.
In the next writing, I would explore a convergence/divergence idea between GC and CL. Stay tuned!
Happy Trading.
Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
CME Real-time Market Data help identify trade set-ups and express my market views. If you have futures in your trading portfolio, check out on CME Group data plans in TradingView that suit your trading needs tradingview.com/gopro/
MGC1!) and Gold Options (GC1!)Gold is often hailed as an effective hedge against inflation. It generally increases in value as the purchasing power of the US dollar declines over time. Does this still remain true? Since January 2013, the US Consumer Price Index increased 29.4% cumulatively, while the 10-year total return of Gold is only 11.3%.
Let’s demystify the gold myth. In fact, gold is by no means among the best-performing investment assets in the past decade! Let’s look at where investing $10,000 in different assets would take you in the past ten years:
• If you held $10,000 in cash, you still have $10,000, a 0% nominal return;
• If you bought a gold ETF fund, you would have $11,300, assuming it tracks gold price perfectly. However, after subtracting an average 0.5% a year in fund expense, you would end up with only $10,800, an annual return of merely 0.78%;
• 5-year bank certificate of deposit (CD) yielded 1.0%/APR in 2013 and 1.5% in 2018. If you put the money in CDs back-to-back, you would have $11,322 now;
• If you invest in a market index stock portfolio, the S&P 500 gained 159% in the past ten years. You would end up with $25,900;
• If you bought bitcoin at $4.43 each in January 2013, you would have amassed nearly $1.6 million from the original 10K, an astonishing 15943% return!
Actual data shows that holding gold, a non-yielding asset, underperformed other investable assets in the past decade.
Gold price endured a double-digit decline, from $1,600 per troy ounce, to as low as $1,000, during the low-inflation period of 2013-2018. It shot up in 2019 as the US-China trade conflict intensified. The outbreak of Covid pandemic pushed gold to a record high of $2,075 in August 2020. As US economy remerged from Covid in 2021, gold price fell back to $1,700. Then, the Russia-Ukraine conflict pushed it back up above $1,900.
However, when the Federal Reserve embarked on the path of rate increases, gold price fell sharply to $1,600. This was a period where US CPI raged between 7-9%, and gold completely failed as a defense against inflation.
US Dollar Is the Primary Price Driver
Gold prices rose on Friday as a rally in the dollar and bond yields paused. COMEX Gold Futures (GC) for April delivery closed up $14.10 to $1,854.60 per ounce.
The rise comes on expectations that higher interest rates are on the way as reports show that US economy is still running too hot to quell high inflation. Dollar index was down 0.35 points to 104.68, while the US 10-year note was paying 3.977%, down 8.4 basis points.
US dollar continues to call the shot for gold as investors assess the Fed's rate path. The above chart shows a perfect negative correlation between gold price and dollar index. When dollar rises, gold falls; and when dollar declines, gold advances.
Last month, the dollar's bounce had weighed heavily on gold. The dollar rallied as a run of hot U.S. labor and inflation data saw traders’ expectations for more aggressive Fed rate increases. A stronger dollar can be a drag on commodities priced in dollar, making them more expensive to users of other currencies.
In recent weeks, gold may have found some support on fears that an aggressive Fed could push the U.S. economy into recession, but a continued rise in U.S. Treasury yields, along with a relatively resilient dollar means limited upside . Rising Treasury yields raise the opportunity cost of holding non-yielding assets, like gold.
Short-term Trading Strategies
At $1,850, gold is neither too expensive nor too cheap by historical standard. As such, I am not in favor of an outright directional trade, one way or the other.
However, the market’s razor-thin focus on Fed rate actions will make a compelling reason for event-driven trades on Gold Futures and Gold Options.
March is a very active month for macro-economic data releases:
• March 8th, Fed Chair Powell will testify on the central bank's semi-annual monetary policy report to the House Financial Services Committee;
• March 10th, Bureau of Labor Statistics will release February employment report;
• March 14th, BLS will release the February CPI report;
• March 22nd, Fed will announce its interest rate decision.
Financial market tends to be sensitive to these data releases, as the latter could deliver huge shocks if actual data goes beyond market expectations.
If you expect an upcoming data release to be bullish on gold, you could express this view with a long futures position on COMEX Micro Gold Futures (MGC).
Each MGC contract has a notional value of 10 troy ounces. At $1,880, a June 2023 contract (MGCM3) is valued at $18,800. Initiating a long or short position requires a margin of $740. This is approximately 4% of contract notional value. In comparison, buying physical gold (i.e., gold bar or gold coin) and gold ETF fund requires 100% upfront investment.
If gold price moves up to $1,950, the futures account would gain $700. Relative to the initial margin, this would equate to a return of +94.6%, excluding commissions.
Alternatively, the same bullish view could be expressed by a call option of COMEX Gold Futures. Each COMEX Gold Future contract has a notional value of 100 troy ounces. At $1,880, a June futures contract (GCM3) is valued at $188,000. A call option on the 1,900 strike is quoted 37.0 on 3 March 2023. Acquiring 1 option requires an upfront premium of $3,700 (100 ounces per contract). If gold moves up to $1,950, the options account would be credited by $5,000 (=(1950-1900) x100), which represents a theoretical return of +35.1% from the original investment of $3,700.
If you are bearish on gold, a short MGC futures or a put option on GC would be appropriate. Futures and options account would gain in value if the price of gold falls.
Similar to investing in physical gold or gold ETFs, the biggest investment risk is betting the wrong direction. However, futures have a built-in leverage. In the case of MGC, each $1 movement in gold price translate into $10 variance in futures account balance. Options have a non-linear payout diagram. As the contract moves deeper in-the-money, options value grows exponentially.
Long-term Trading Ideas
After the active central bank action period is over, will gold price trend up or down? What would be the primary driver of gold price? Inflation, US dollar, interest rate, economic growth, or geopolitical crisis? All are possible, maybe a little bit of each.
My research reveals that gold price has a relatively stable relationship with WTI crude oil (CL). Over the past ten years, each 1,000 barrels of WTI (1 CL) sell at a price between 150 and 300 ounces of gold for about 80% of the time.
We could visualize an oil producer wanting to be paid by gold. When dollar fluctuates, he would adjust the dollar selling price to keep his gold acquisition stable. Therefore, whenever the price range is breached, gold price has a strong tendency of falling back in.
In the next writing, I would explore a convergence/divergence idea between GC and CL. Stay tuned!
Happy Trading.
Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
CME Real-time Market Data help identify trade set-ups and express my market views. If you have futures in your trading portfolio, check out on CME Group data plans in TradingView that suit your trading needs tradingview.com/gopro/
Jim W. Huang, CFA
jimwenhuang@gmail.com
jimwenhuang@gmail.com
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