I’ve been sporadically successful at shorting gold for years. From the end of 2018, through March 2020, and into H1 2022, I’ve encountered the unyielding resistance of the long gold crowd. These investors are as steadfast as they come, making them a tough group to sway. In this article, I will delve into the intricate tapestry of the global macroeconomic landscape and the myriad factors that bear upon the price of gold.
Firstly, I will explore the general portfolio theory of using a short gold position as an optimal market tail risk hedge. This can safeguard against a persistent surge in real yields, which exerts downward pressure on stocks, bonds, and inflation hedge assets such as commodities and TIPS. Consequently, this diminishes the efficacy of traditional 401K and risk parity portfolios. In short, the mechanism behind this tail risk is a bond hedge that operates in reverse.
Most strategies designed to shield portfolios during downturns involve diversification into a blend of equities, bonds, and inflation hedge assets like commodities. However, the predicament lies in the fact that higher real rates can exert downward pressure on all these asset classes, rendering this strategy imperfect in certain scenarios.
I advocate for a completely different approach. I propose holding a small portion of a portfolio in tail risk hedges that perform exceptionally well during catastrophic global economic events – events that have historically occurred time and time again. I view this as a perpetual insurance policy, akin to renewing it regularly. This could take the form of deep out-of-the-money options contracts, yielding thousands of percentage points in returns during extremely adverse global economic and financial market scenarios.
I believe this approach is significantly more effective than a diversified portfolio, as it allows a portfolio to take on concentrated risk in equities during favorable times. This can be done with the knowledge that the insurance policy of tail-risk hedging options will outperform if the majority of the portfolio, heavily skewed towards risk, takes a downturn. While many of these tail-risk hedges may expire if the markets flourish, in adverse scenarios such as financial crises, which many economists view as unpredictable, it provides much stronger protection compared to traditional forms of portfolio diversification. Furthermore, it avoids diluting returns through overly diversifying. For many passive investors, the approach I recommend should constitute a minuscule component of a larger portfolio, held consistently over time. This stands in stark contrast to diversifying risk (and return) through traditional portfolio theory, such as a 60/40 stock/bond portfolio.
It is worth noting that portfolio insurance hedges bear fruit only a small percentage of the time. John Paulson’s housing short in ’08 marked one of the most substantial returns in financial history. Many have likened it to buying flood insurance in a desert – or more aptly, what was perceived to be a desert. Consensus perceptions do not always mirror reality, and identifying these small windows is where alpha is generated. This philosophy has been the guiding force in my entire investment career.
The most reliable forward indicator of gold prices is the use of inflation-adjusted US T-bond yields as an inverse proxy for gold prices. When inflation-adjusted or real yields increase (indicating a decline in inflation or inflation expectations, and a rise in interest rates), gold correspondingly depreciates. This is intuitive, as gold is an asset that hedges against inflation, yet yields no interest, making it less competitive when rates climb and inflation stagnates or decreases.
We have recently witnessed a breakdown in this inverse correlation, with real yields surging over 200 basis points and gold smashing through all-time highs. How long can this anomaly persist? The answer eludes me, but it is inevitable that this cannot carry on indefinitely. Either real US Treasury yields and the USD will retreat, or gold will give way, as all the aforementioned factors have escalated to unprecedented levels.
I am holding firm to my $1100 gold price target, based on the extensive surge in real yields, without a commensurate decline in gold. The manner in which gold prices have defied the surge in real yields and a consistently robust USD indicates an expectation of the transient nature of higher anticipated real yields and restrictive monetary policy. Essentially, this assumes that real yields will recede as the Federal Reserve executes an anticipated (as reflected in the market) 100 to 150 basis points in Fed Fund rate cuts this year.
As illustrated below, there is a 95.4% market-implied likelihood of 100bp of rate cuts or more this year, a 78.8% probability of 125bp of cuts, and a 45.2% chance of 150bp or more cuts. The current target Fed Funds rate stands at 5.25%-5.50%.
The market has already completely priced in a 25-basis point cut by the June FOMC meeting at a 99.4% expected probability, and the likelihood of two cuts by September has been pegged at 99.7%. The anticipated outcome regarding a 25bp cut in March is evenly split. These probabilities are depicted below.
Are these expectations extravagant? The market evidently thinks otherwise, but I remain more skeptical. I anticipate that core inflation in the United States will not comply – in other words, it will not decelerate below two percent annually. This would preclude the Fed from embarking on a sizable policy easing cycle.
