Gold’s “crazy surge” signals that “something bigger” is happening
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The historic surge in gold prices signals that changes far more fundamental than inflation or deflation are brewing.
On October 16, the gold rally showed no sign of abating, hitting a new historic high for the fourth consecutive trading day and breaking through the $4,300 barrier for the first time. Since the start of this year, gold has risen more than 60% in total.
(Gold has risen 64% so far this year, as of October 17)
Bloomberg macro strategist Simon White points out that the key message gold conveys is that it is not just an inflation hedge against currency depreciation, but a hedge against the entire financial system—from severe credit contractions to large-scale fiscal deficit monetization.
Simon believes that as the risks of government debt and various credit products intensify, gold held in physical form, because it is not anyone’s liability, becomes the ultimate unassailable collateral.
Therefore, regardless of whether the market faces inflationary shocks or a deflationary crisis in the future, demand for gold may continue to surge.
Gold is more than just an inflation hedge
Simon says the market’s biggest misconception about gold is seeing it only as an inflation hedge and a tool for protecting against currency devaluation. But historical data show that gold performs best during both very low and very high inflation.
If gold were simply an inflation hedge, its returns should increase as inflation rises. But the reality is otherwise.
During the severe deflation of the 1930s, even after the U.S. government forced private holders to sell gold at $20 per ounce and then revalued it to $35, gold still went up. If the market hadn’t been shut down then, the increase might have been even greater.
The U.S. confiscated gold back then because people started hoarding it during the Great Depression, worsening the deflation crisis. Both inflation and deflation are merely symptoms of rising stress in the financial system.
(Gold performs well regardless of inflation rate)
The real solution is high-quality collateral, which is exactly what the market desperately needs and what’s driving gold prices higher.
Hidden risks in the credit market
One of the risks the market is betting on is a major credit contraction.
According to Orlock Advisors analyst Russell Napier, the surge in gold prices mainly foreshadows an impending credit crisis. Although the spreads between high-yield and investment-grade credit have recently narrowed, that doesn’t mean risk is receding.
The spread is measured relative to the “risk-free” yield of government bonds, but given the massive fiscal deficits in the U.S. and elsewhere, the so-called “risk-free” status of government bonds can no longer be taken for granted.
More importantly, if you adjust using interbank swap spreads, you’ll find that the actual credit spread (the interest rate differential between corporate bonds and government bonds) is even higher.
This means it’s more expensive for the private sector to borrow, and banks face higher costs when taking on risk themselves—in short, borrowing is costlier and riskier now.
(Credit spreads are even higher after adjusting for interbank swap rates)
However, the situation is changing. Reports indicate that with renewed global trade tensions and a company called First Brands, which owes billions of dollars, declaring bankruptcy—with more than $2 billion in funds reportedly “disappearing”—credit spreads have recently widened again.
As JPMorgan CEO Jamie Dimon warned:
When you see one cockroach, there are likely more nearby.
The gold market’s performance aligns with Dimon’s view. In a deflationary credit event where cash flow is interrupted or badly damaged, holding a non-financial asset that’s not anyone’s liability will be one of the few viable hedge options.
Government debt risks are equally severe
Besides the private sector’s debt service ability, increasingly spendthrift governments are also a major source of market unease.
Governments are facing unprecedented peacetime and non-recession fiscal deficits. Unlike companies, sovereign governments can escape trouble by printing money—a core concern for the market.
The expectation that large fiscal deficits will eventually be “monetized” is undoubtedly another force driving gold demand. Such behavior will severely erode the real value of fiat currencies.
Federal Reserve Chairman Powell hinted this week that after quantitative tightening ends, quantitative easing (QE) might return at astonishing speed.
A decline in confidence in government collateral (i.e., government bonds) is already showing up in rising term premiums—over the past year, this has been the main driver of higher yields in most major developed markets.
(The rise in term premiums fueled most of the increase in major developed market government bond yields last year)
The common winner under two types of shocks
Currently, the U.S. Treasury market is at a critical juncture, with low volatility often signaling larger yield swings to come. Regardless of whether the next shock is inflationary or deflationary, gold will be sought after.
If there is an inflationary shock, gold will play its familiar role as a tool to hedge against currency depreciation. But if it's a credit crisis and deflation, the demand for high-quality collateral will become even more pressing.
In a credit contraction, non-sovereign debt will be hit first, but in the end, even government debt is hard to escape. Faced with massive deficits and a debt-deflationary economy, monetizing sovereign debt will become inevitable.
At that point, the nominal value of government debt might be protected, but its real value would be destroyed, letting all types of traditional collateral suffer across the board.
In such a scenario, gold—unless confiscated by decree once again—will continue to maintain its “real” value. That is exactly what its historic price surge is telling us.
Risk Warning and DisclaimerThe market carries risks and investment should be made with caution. This article does not constitute personal investment advice, nor does it take into account the particular investment goals, financial situation, or needs of any specific user. Users should consider whether any opinions, views, or conclusions expressed herein fit their circumstances. Investments made accordingly are at your own risk. ```