The Great Gold Sell Off- It Is Not Inflation Expectations

I was reading this article earlier today at Credit Writedowns, where the author, Edward Harrison, was throwing out the idea that the gold sell off is driven by lower inflation expectations. Here is an excerpt.

So what is going on here? Personally, I like the way Pawel Morski puts it.

Gold – unlike bank deposits, equity or bonds, or even banknotes – it’s separate from the real economy; it’s what you invest in when you want to take a breather from what’s happening in the real economy. That’s actually only a sensible thing to do in pretty extreme circumstances. Gold returns are utterly crushed by equity markets in the long term – to a really astonishing degree for those economies where we have continuous equity markets. Compared with shares in pre-revolutionary China or pre-war Poland, gold returns look pretty good.

I have been saying that the gold bull is over – at least for now – since the beginning of 2012. In my ten surprises for 2012, I put my prediction of a gold bear this way:

“Gold continues to lose its luster: gold wins when financial repression, defined as negative real interest rates, is the greatest. The higher the gap between inflation and long rates is, the higher gold will go because it goes from being a burden that has zero yield to being an asset that holds purchasing power amid government-sponsored wealth destruction. I think the inflation cycle has peaked. European inflation is coming down, Indian inflation and Chinese inflation are coming down. And policy rates, particularly in the US and Europe have no room to go much lower. That’s not gold bullish.”

And this continues to be the case. Rates cannot go any lower and inflation expectations are not coming unanchored. That’s my view.

So, can lower expectations really be at the root cause of the gold's pounding. My guess is that it is unlikely, at least looking at current inflation expectations. As evidence, the following chart shows inflation expectations baked into the 5-year and 10-year treasury markets, as calculated by the difference between treasury yields and their corresponding TIPS yield rates since the beginning of 2012.



 Yes, inflation expectations have come down, but at this juncture they do not appear to be flashing a deflationary signal. In fact, inflation expectations appear to be trading well within a broader range for both the 5-year and 10-year.

Of course gold could be signalling a deflationary event, but using the 2008 recession as a benchmark (the last deflationary event and the only one that corresponds with TIPS yield data), that assertion seems weak. The following is a chart of 5-year and 10-year inflation expectations versus the price of gold in 2008 and 2009.



Looking at this chart, gold prices appear to move more in tandem with inflation expectations. Maybe even up to leading inflation expectations by at most three months. Going through the calculations, the R-squared tops out around 40% in or around a 3-month lag using the 2008 and 2009 data.. That R-squared is not a resounding affirmation of the thesis that gold is a leading inflation indicator.

That aside, lets assume that gold prices will always lead inflation expectations by at least three months, essentially assuming an R-squared approaching 100% in the above example. That relationship appears to have broken down recently, as the price of gold been falling since the beginning of October last year, or about seven months. See the chart below showing 5-year and 10-year inflation expectations versus the price of gold.



Gold in undoubtedly in a bear market, but it is not because of a reduction or a likely reduction in inflation expectations.