September 13, 2011: Gold and Treasuries are No Contradiction

Gold and Treasuries have been rising simultaneously lately, leaving many investors scratching their heads. An economy cannot be experiencing inflation and deflation at the same time, so why are they both going up?

The misunderstanding stems from a lack of understanding of gold and the relative nature of exchange value.

It is pretty clear that our economy is more worried about deflation than inflation right now. With unemployment at 9%, it is hard to imagine a prolonged inflationary cycle. It is important to realize that inflation only gets nasty when the economy is running at full speed and our economy currently has far too much slack.

So if deflation is the real worry, why is gold going up too? Don’t higher gold prices indicate higher inflation expectations?

A key symptom of deflation is a flight to currency over risk assets; the exchange value swings in currency’s favor. In a deflation, currency is king because it allows you to sit on the sidelines and scoop up assets and commodities as prices drift (or plummet) lower and lower.

When comparing the price movements of gold to a basket of other commodities, it is very clear that gold is different because gold has unique price movements that do not correlate with the rest of the commodity universe. This low correlation exists because gold trades as an alternative currency. Even though it is not twintopt in any modern economy, wealthy individuals (and governments) still trade it as if it were a currency.

So, when gold and Treasuries are both going up, you are not witnessing a market contradiction but a flight to the broad asset class of currencies. Within this broad asset class, investors have choices and sometimes they prefer gold over Treasuries or vice versa.

It’s pretty simple to understand when viewed from a perspective of relative exchange value. The confusion arises because we are conditioned to always view exchange values in dollars. In reality, exchange values can be expressed in an infinite number of ways and one way of expressing exchange value is no more correct than others. When investors stampede into gold and dollars simultaneously, we see big movements in the price of gold measured in dollars because the market for gold is much smaller than the market for dollars. It is entirely plausible for investors to want both, but we see relatively higher prices (in dollars) for gold.

This argument does not dismiss gold’s use for inflation protection. Significant inflation normally manifests itself in fiat currencies (unless we have massive gold discoveries). Therefore, in an inflationary environment people value the relatively fixed currency of gold more than the expanding fiat currency experiencing the inflation. In this situation, the shift is happening within the currency universe.

In summary, inflation expectations are a sufficient but not necessary condition for gold to rise. In fact, gold can still perform very well relative to risk assets during a deflation as investors stampede into currencies.

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