Can Gold and Bonds Both Be Right?

In my opinion, the crisis and the sharp recession of the past two years and the subsequent rescue packages around the globe did not provide the necessary catharsis that recessions need to bring to economies.

~ George Athanassakos

I chose a recent article from the Globe and Mail for today’s Friday Food for Thought. This one is by George Athanassakos, a professor of finance. He has been wondering about what the rise in both bonds and gold means for a couple of years now and provides some updated insights in this article: Who Is Right? Bond Bulls or Gold Bugs?

Usually a rising gold price indicates that investors see inflation coming. Rising bond prices, and the accompanying lower yields, usually portend slowing economic conditions, or some degree of deflation. Can both be right? Which one will have the greatest staying power?

Inflation or Deflation?

Mr. Athanassakos believes that gold and bonds can’t both be right. His money is on gold. He does not, however, buy into the idea that gold is only rising because the U.S. dollar is falling. Rather, he believes that the fall in the greenback and the boost in gold prices are both consequences of expected inflationary pressures in the future.

That inflationary pressure will likely emanate from more quantitative easing. “Markets and economies around the world have become hooked on low interest rates and liquidity infusions.” When traders believe that monetary authorities will prime the liquidity pump by lowering interest rates or providing more QE, markets rally. When it looks like central banks might tighten monetary policy, markets throw a tantrum and central banks reopen the meth clinic.

Mr. Athanassakos is quite certain that central banks will continue to deliver the narcotics the market craves, driving down interest rates in the short term, but ultimately creating an inflation problem. He sees higher gold prices as a “reasonable reaction” to the deleterious effects inflation will inevitably have on financial assets.

It’s a Matter of Timing

I don’t necessarily disagree with the author of today’s article. I think there’s a decent chance that the scenario plays out just as he expects. But as I mentioned in my recent article on GIC strategy, it’s important for investors to answer two important questions:

  1. What was I thinking?
  2. What if I’m wrong?

Mr. Athanassakos clearly has question number one covered. But what if things don’t play out as expected? There are equally valid reasons why inflation may not be a problem for quite some time. Another recent article, entitled Bernanke to Repeat Japan’s Mistakes, made a pretty good case for why QE may not necessarily create inflation. After all, the Japanese, on the advice of a certain Princeton professor named Ben, have been following the Keynesian yellow brick road for about 20 years now and have yet to create any spark of inflation.

While it may seem obvious that continual money supply expansion would lead to inflation, we have to wonder how long it will take to do so given the Japanese experience. It’s possible that Mr. Bernanke could have just as much trouble getting the QE flint to spark inflation as the Bank of Japan. If that happens, then both gold bugs and bond bulls could be right for much longer than you would think. However, if markets begin to believe that the Fed will not ultimately create any inflation, gold could go down, perhaps precipitously.

What about Biflation?

You will recall that I recently wrote about the concept of biflation, which is basically an economic condition whereby we experience inflation in some sectors while others are flat, or even deflationary. We have witnessed this phenomenon recently, as commodity prices have soared while U.S. housing prices continue to fall.

Perhaps biflation is a good explanation for the apparent contradiction in the simultaneous rise of bonds and gold. Bonds are rising because investors see an economic recovery that is flaccid at best, while gold is rising because they believe central banks will try to fight deflation with everything they have, even if it means creating bubbles in sectors like commodities. So investors are equally afraid of the disease and the cure.

My 2 Cents

It would be easy to say that you should be invested in gold and other commodities if you buy the inflation thesis, but stick to cash and bonds if you think deflation will remain stubborn. But the debate is so much more complicated than that. Here are just a few of the questions I’m currently asking myself:

  • Gold has risen more than 500% over the last decade or so. At what point will Fed-induced inflation be priced in?
  • Everyone expects the Fed to comply with more QE. What if they don’t?
  • What if they do deliver on QE, but it doesn’t work? What if the inflation never comes?
  • What if QE only makes things worse by magnifying the biflation we are currently experiencing? The inflated sectors could form bubbles that pop even as the deflationary sectors continue to worsen.
  • There are still a number of anvils hanging over us out there. Any one of them could be an “all bets off” factor if it fell on us. I’m thinking about sovereign debt issues, and the U.S. housing and mortgage crisis that just doesn’t seem to want to go away.

I wrote about the foreclosure issue over a week ago when it was very sparsely reported in the mainstream media, but we are now seeing a lot more headlines pop up on the topic. It’s starting to look a little like the subprime crisis did in late 2007. If Mr. Bernanke tells us the problem is “contained”, that will be the cue to abandon ship. It seems many insiders have already done so.

I agree with Mr. Athanassakos on the need for a more thorough economic catharsis and structural financial changes. He made a reasoned, sensible case for buying gold, but so have the folks on the other side of the trade. That leaves me uncertain enough to maintain a heavy cash weighting in spite of the recent market melt-up. I haven’t heard anyone answer the questions above in such a way that makes me want to put my money where their mouth is.

What’s your view on the bonds vs. gold contradiction?

Written by Kim Petch

9 Responses to Can Gold and Bonds Both Be Right?

  1. Many smart people are using their brains to develop logical views as to what to be invested in today. But the markets today are not governed by logic. Everyone is scared. In that environment, emotion can take things in any direction and to any degree. How do you predict the direction of panic attacks?

    Everyone has to invest in something. So I can’t fault people for doing this. But my view is that we are directing our mental energies in the wrong direction. We need to solve the emotional problem. To do that, we need to be open about our worries that we have destroyed the free market system with our non-stop promotion of Get Rich Quick investing “strategies” in recent decades.

    If the root problems are not addressed, my view is that no asset class will provide a good return. What is gold worth if our way of life is gone? What are bonds worth to people living through the Second Great Depression?

    My view is that we are focusing on (relative) trivialities. Again, I am not being critical. People who are in life-threatening circumstances often talk about baseball scores to get their minds off the thing that they cannot bear to face. We are in pain and this is what people in pain do.

    Still, I think we need from time to time to hear reminders that the old days of worrying about which asset class is best may be on the way out. There is no such thing as “personal finance” in a world in which the economic and political systems have fallen. Things are of course not quite that dire yet and my personal belief remains that we will turn the car around before it goes over the cliff. But I do think that we need to get some responsible people (are there any left in the economics or political fields?) to address the drivers of the current troubles.

    It was a quote from Paul Krugman that i just tweeted that put me in this somber mood. He said (referring to the new mortgage mess): “The question is whether our economy is governed by any kind of rule of law.” It didn’t trouble me so much that he said it. What troubled me is that I would have a hard time arguing that he is wrong. Heaven help us all!


    • The rule of law has been made so complex that very few people can understand it. Maybe the mortgage problems weren’t discussed earlier because neither reporters nor politicians understand the ins and outs of a mortgage-backed security. These structural problems have become the container at the back of the fridge that you ignore for a couple of weeks. When you finally notice it’s there, you’re afraid to look inside and so you leave it to ferment a little longer.

      I agree that it’s time to lift the lid on that container, deal with the stench, and throw it away. The financial system needs to regress a little to a system of simpler rules that we can all understand and is not too complicated to regulate properly.

      The ever-rising stock market is the ultimate delusion. There is nothing fundamental driving it except for the firm belief that the Fed will print money.

      Thanks for stopping by Rob.

  2. I wonder if the Japanese debt bubble is set to explode someday. Could it one day shift abruptly from deflation to hyperinflation?

    Some of it comes down to trust. There has been a loss of trust in recent years as it has become obvious that the system has not been working with transparency and honesty, and governments subsidize losses with taxpayer money while allowing private owners to keep private gains. This corporatism and crony capitalism is partly responsible for our current mess, and is not helping us get out.

    I personally believe that, in spite of huge interference and mismanagement, technological advances lead to a bright future in the longer term. In the medium term, the monetary system may suffer further shocks in the meantime.

    I am allocating 10% to precious metals as insurance and as an alternative currency. If prices skyrocket I may sell some to buy cheap stocks. If prices collapse but I don’t see the fundamentals as having changed (i.e. Volcker days), I will purchase more PMs.

    • I have heard John Mauldin call Japan “a bug in search of a windshield” many times, but I have no idea how long it might take before the collision happens.

      It does seem like precious metals were the trade of the last decade and are shaping up to be even stronger in this decade. Again, the question of timing is key. At what point is hyperinflation priced in? I think that even the most ardent gold bull would concede that when the trade finally does unwind, it will do so hard and fast.

      Having said that, a 10% allocation to PM doesn’t seem overdone. Thanks for your comment Kevin!

  3. Gold is right longer term. Both are going up because of the QE that’s being orchestrated by the Fed. Money is looking for an outlet during the early inflation so all assets are going up. Coupled by the fact that people are chasing yield.

    In his book, “Dying of Money”, Jens. O. Parsson explains that everyone loves an early inflation. Government spending goes up, assets go up in value, but the cost of living doesnt’ go up (yet). I think we are in this stage where money is flooding the system and looking for an outlet.

    This means that longer term, gold is the right bet. But, in the meantime bonds will continue to go up as well.

    • I think you’re right. I’ve read about the book you mentioned on Zero Hedge and wondered whether it might be a good read. I’m guessing you would recommend it? If so, I’ll see if I can snag a copy an write a review here.

      Gold has definitely been a great trade over the past decade. I wouldn’t be surprised to see it trade well in the current decade as well, unless Ben & Co. get religion and realize that they can’t engineer a truly capitalist economy by plastering over the holes with paper money.

      • Actually if you Google it, you’ll find some PDF versions online. Not sure if it’s legit or not, but the book is out of print so finding a print copy may be tough…

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