Gold: Growth Asset or Insurance Policy?

Should investors own gold to capitalize on price increases, or hedge against the incoming recession? The answer may depend on monetary policy.

Markets at a Crossroads

Inflation has fallen from its peak, but remains stubbornly high. The question for gold investors is: will real yields (nominal yields minus inflation) start to stagnate or fall, or will the Fed’s tightening push them higher still?

The market is forecasting that real yields will soon begin to stall out or even drop. Such a shift would be welcome news for gold, as historically, the metal has thrived when real yields are falling.

However, the Fed has indicated that more rate hikes are required to win the battle against inflation. Federal Reserve Chair Jerome Powell has maintained a hawkish tone in all his recent public appearances, especially at this year’s Jackson Hole Economic Symposium on August 24-26.

Typically, this would be bad news for gold. But there is a caveat: If hawkish policy continues unabated, the risk of a downturn rises exponentially. The economy has proven surprisingly resilient over the last year and a half, but signals from the real estate and banking sectors show that the economy’s breaking point is closer than we would like to believe. If the economy does falter under further tightening, gold will become the go-to insurance policy like it did during the previous two recessions: the Global Financial Crisis and COVID-19.

Performance Update

The recent strength in the dollar has been weighing on gold:

Silver has been highly correlated with gold, though more volatile:

The ‘Wait and See’ Monetary Policy

CPI has leveled off to 3.2%, down from 9.1% in April 2022. This is still far above the Fed’s target of 2%, and some policymakers believe knocking the inflation down the final peg will be the most challenging episode of their 3-year long battle.

Powell noted that the Fed is, “navigating by the stars under cloudy skies.” Of course, that is the nature of monetary policy: trying to control an infinitely complex system with blunt instruments. The Fed is keeping purposefully tight-lipped about their next policy move, only indicating that it will be data driven and that they will proceed with caution. Powell’s vague remarks haven’t spooked investors yet.

In The Clear From Recession?

So far the Fed’s extreme rate hikes have managed to avoid financial catastrophe… if we ignore some of the largest bank failures in history earlier this year. Many thought defeating inflation would require a painful recession, but such fears have yet to materialize.

Does that mean we’ve had our soft landing and are in the clear from a deeper recession?

No. The economy takes years, even decades, to fully adjust to monetary policy decisions.

The truth is, the United States has never seen such drastic loosening as we did during COVID-19, and such drastic tightening that we have seen from early 2022 until now. Fifty years from now, people will likely look back in astonishment at today’s policies.

The question remains: What will they remember as the consequences of the money printing whipsaw? Another Great Recession? An inflationary spiral? Neither?

Real Estate Canary in the Coal Mine

Right now, all eyes are on the commercial real estate sector.

The health of the economy is heavily tied to the health of banks, and the health of banks is heavily tied to commercial real estate.

In the low interest-rate environment, banks looked to safe bets to shore up profits — namely loans to buy commercial real estate. So, they drastically increased their exposure to commercial real estate over the last decade. Recent rate hikes have now sent the sector into a meltdown.

According to the Wall Street Journal: “The banks are in danger of setting off a doom-loop scenario where losses on the loans trigger banks to cut lending, which leads to further drops in property prices and yet more losses.”

The Vanguard Real Estate ETF (VNQ) has fallen over 30% from its peak in December 2021. During the 2008 Global Financial Crisis, the index fell 77% from peak to trough.

Real estate prices have much further to fall before we see a “buyers’ market” again.

If further substantial rate hikes become necessary, the repercussions on banks, real estate, and corporations would likely be markedly more severe than the challenges witnessed in the past year. If this relentless tightening trajectory continues, the ensuing recession could catalyze a mass move away from risk assets and toward safe havens like gold.

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