Thesis: Long gold (NYSEARCA:GLD) (But not Bitcoin (BTC-USD)) and short Treasuries (NASDAQ:TLT)
The landscape of the global political arena is becoming increasingly complicated. The unfolding war scenarios in both Israel/Hamas and the Russia/Ukraine region have positioned the US in a challenging predicament. In an effort to support allies engaged in two simultaneous and costly wars, the US will inevitably face significant financial strain, prompting potential money-printing exercises. This, by default, would be bullish for gold, an asset historically viewed as a safe haven during geopolitical and economic uncertainties. Conversely, the increased spending and related debt accumulation by the US can heighten credit risk, which is bearish for US treasuries.
Persistent Inflationary Pressures
As we edge closer to winter, energy prices are set to spike, exacerbated by the ongoing wars. Two of the world’s largest energy producers, the Middle East and Russia, are now embroiled in conflict. This geopolitical unrest threatens to disrupt the global energy supply chain. The US is not immune to these pressures; its petroleum reserve levels have been dwindling, presenting a considerable red flag. Given the historical correlation between energy prices and inflation, the upward pressure on inflation is expected to persist. One of the most pertinent historical analogs is the 1970s oil crisis and its subsequent impact on global inflation and gold prices.
1970s Oil Crisis: Context and Inflation
During the 1970s, the world experienced two significant oil crises. The first began in 1973 when the members of the Organization of Arab Petroleum Exporting Countries (OAPEC) proclaimed an oil embargo. This was in retaliation for the U.S.’s support of Israel during the Yom Kippur War. The embargo resulted in oil prices quadrupling by 1974. The second oil shock was in 1979, precipitated by the Iranian Revolution, which once again saw a sharp spike in oil prices.
These oil shocks had profound economic implications. Oil, being a primary input in the economy, led to a surge in production costs across various sectors. This phenomenon, termed “cost-push inflation,” saw prices of goods and services rising as the increased cost of energy impacted production and transportation costs globally.
Gold price analog: 1970s
The 1970s were also significant for the gold market. Prior to the decade, the Bretton Woods system pegged major currencies to the U.S. dollar, and the U.S. dollar was pegged to gold. However, President Richard Nixon effectively took the U.S. off the gold standard in 1971, which meant currencies were no longer backed by gold. As currencies started to float freely, and with inflation rising sharply due to the oil crisis and other factors, gold started to be seen as a hedge against inflation. From 1971 to 1980, the price of gold increased dramatically. Starting at approximately $35 per ounce in 1971, it peaked at over $800 per ounce in 1980, marking an increase of over 2200% in less than a decade.
We believe the US is in significantly worse shape than the US was back in 1970, with a significantly higher national debt, weaker exports, and stocks near all-time highs. We believe the gold prices are highly attractive, especially if we break into the 2000 territory; we expect 2,000 to be the solid base for it to go much, much higher.
Net net, we believe the 1970s provides a compelling historical analog showing how geopolitical events, such as war (Yom Kippur War, Iranian Revolution), can disrupt energy supplies, leading to sharp rises in energy prices. This, in turn, can drive inflation rates higher. In such an environment, with uncertainties in fiat currencies and rising costs, gold became a preferred asset for many, driving its prices to unprecedented levels.
Federal Reserve’s Dilemma
The US Federal Reserve, under Jerome Powell’s leadership, finds itself in a tight spot. A faltering economy, combined with the prevailing geopolitical chaos, makes it impractical for the Federal Reserve to consider hiking interest rates further. However, with soaring inflation, there’s also no room to cut rates. Maintaining the status quo, although seen as a possible course of action, is still problematic. Persistent inflation, even without rate adjustments, benefits gold as a hedge while making US treasuries less attractive due to increased credit risk and lowered real returns.
How to take advantage of the situation
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Direct Gold ETFs (GLD), (IAU), (SGOL): These ETFs provide direct exposure to the price of gold. Although they have low volatility and low risk, gold miners can provide more leverage and perhaps higher returns for investors with a high-risk appetite.
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Gold Miners (GDX): Investing in gold mining companies provides a leveraged exposure to gold prices. If gold prices rise, the profits of these mining companies can increase significantly. However, they also come with company-specific and sectoral risks, and we recommend sector-wide ETFs of producers rather than buying individual miners unless readers have in-depth knowledge of natural resources and model each company’s cashflows.
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Junior Gold Miners (GDXJ): These smaller mining companies can offer even higher growth potential. However, they also come with increased risks, especially in volatile geopolitical landscapes.
| ETF Name | Key Features | Pros | Cons |
|---|---|---|---|
| SPDR Gold Trust (GLD) | – Largest gold ETF by assets. – Directly holds physical gold. | – Highly liquid. – Direct exposure to gold prices. | – Relatively higher expense ratio. |
| iShares Gold Trust (IAU) | – Directly holds physical gold. | – Lower expense ratio compared to GLD. – Good liquidity. | – Slightly less liquid than GLD. |
| VanEck Vectors Gold Miners ETF (GDX) | – Invests in gold mining companies. | – Potential for leveraged returns compared to gold prices. – Diversified exposure within the gold mining sector. | – Exposed to company-specific risks. – Volatility can be higher than direct gold investments. |
| VanEck Vectors Junior Gold Miners ETF (GDXJ) | – Focuses on smaller gold mining companies. | – Higher growth potential compared to established miners. | – Higher volatility. – Exposed to greater company and geopolitical risks. |
| Aberdeen Standard Physical Swiss Gold Shares ETF (SGOL) | – Stores gold in Switzerland. – Directly holds physical gold. | – Additional geographical diversification for gold storage. – Competitive expense ratio. | – Less liquid than GLD and IAU. |
Short Treasuries
| ETF Name | Key Features | Pros | Cons |
|---|---|---|---|
| ProShares UltraShort 7-10 Year Treasury (PST) | – Seeks to provide 2x the inverse daily performance of the ICE U.S. Treasury 7-10 Year Bond Index. | – Provides leveraged inverse exposure. – Suitable for short-term tactical positions. | – Daily reset can lead to compounding issues. – Not ideal for long-term holdings. |
| ProShares UltraShort 20+ Year Treasury (TBT) | – Seeks to provide 2x the inverse daily performance of the ICE U.S. Treasury 20+ Year Bond Index. | – Offers leveraged exposure to longer-dated treasuries. – Useful for short-term bearish views. | – Can be highly volatile. – Daily reset affects long-term performance. |
| Direxion Daily 20+ Year Treasury Bear 3X Shares (TMV) | – 3x the inverse daily performance of the ICE U.S. Treasury 20+ Year Bond Index. | – High leverage can amplify returns. | – Very high volatility. – Not suitable for risk-averse investors or long-term holdings. |
| iPath US Treasury 10-year Bear ETN (DTYS) | – An exchange-traded note (ETN) providing inverse exposure to 10-year treasuries. | – Direct inverse exposure without leverage. – Suitable for those avoiding compounding issues. | – Being an ETN, credit risk of the issuer is involved. – No leverage may be a con for those seeking amplified returns. |
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Leveraged Inverse ETFs (PST), (TBT), (TMV): These ETFs provide amplified inverse exposure, which can benefit if U.S. Treasury prices fall and yields rise. Their leveraged nature can offer higher returns on short-term moves. However, the daily reset mechanism can lead to compounding issues over longer periods, making them more suitable for short-term trades.
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Direct Inverse ETN (DTYS): For investors wary of the daily reset issue of leveraged ETFs, DTYS provides direct inverse exposure without leverage. Its structure as an ETN means it carries the credit risk of the issuer, but it might be more predictable in its performance over longer durations compared to leveraged ETFs.
The choice between leveraged ETFs and direct inverse ETNs depends on an investor’s risk tolerance, investment horizon, and views on leverage.
For investors who are seeking instruments without leverage, we recommend DTYS, which does not involve leverage or outright shorting 30-year treasury through a reader’s broker.
Scenario analysis
Scenario 1: Rising Inflation and Geopolitical Tensions
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Gold: Traditionally, gold is seen as a hedge against inflation. When inflation rises, the purchasing power of fiat currencies diminishes, leading investors to seek assets like gold that can retain value. Additionally, during geopolitical tensions, gold often acts as a safe-haven asset, attracting inflows.
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U.S. Treasuries: In an environment of rising inflation, the value of fixed payments from bonds becomes less attractive, leading to falling bond prices (and rising yields). Moreover, increased government spending to support wars can raise questions about a country’s fiscal health, putting further pressure on its bonds.
Pairs Trade Outcome: In this scenario, the gold position should appreciate, while the short Treasuries position should also generate a profit from declining bond prices.
Scenario 2: U.S. Fed Raises Interest Rates Sharply
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Gold: Higher interest rates generally increase the opportunity cost of holding non-yielding assets like gold. Thus, gold might face downward pressure.
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U.S. Treasuries: When the Fed raises rates, newly issued bonds come with higher yields, making older, lower-yielding bonds less attractive. This leads to a decrease in bond prices.
Pairs Trade Outcome: Although the gold position might decline due to rising rates, the short Treasuries position should generate a profit, offsetting the gold’s loss.
Scenario 3: Economic Downturn and Flight to Safety
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Gold: In times of economic uncertainty, gold can benefit as a safe-haven asset, seeing increased demand.
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U.S. Treasuries: Economic downturns usually lead to a flight to safety, where investors flock to assets perceived as “safe,” like U.S. Treasuries. This can push bond prices up (and yields down).
Pairs Trade Outcome: Both the gold and Treasuries positions might appreciate due to their safe-haven status. However, since the strategy is short on Treasuries, the appreciation in the gold position can offset losses from the short Treasury position.
Why the Pairs Trade Acts as a Hedge
By pairing these trades, investors can reduce the risks associated with unexpected market movements. If they had a directional bet on just one asset (either gold or Treasuries), they would be more exposed to unfavorable moves. By being long on one and short on the other, they aim to balance out potential gains and losses depending on how market scenarios unfold.
The idea is to profit from the relative performance difference between gold and Treasuries rather than their absolute performance. This makes the pairs trade a strategy that seeks to hedge out broader market risks and instead focuses on the specific dynamics between the paired assets.
Bitcoin is fool’s gold, not gold.
Bitcoin (OTC:GBTC) (BTC) (COIN) and gold are both frequently referred to as “store of value” assets, but they behave differently due to their intrinsic properties, adoption stages, and market perceptions. Here’s why we believe Bitcoin is seen more as a risk asset compared to gold, which is a proven and tested inflation hedge.
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Volatility and Market Behavior:
- Bitcoin’s price has been characterized by high volatility since its inception. The digital currency has seen dramatic price swings, which can be attributed to factors such as regulatory news, technological advancements, market sentiment, and macroeconomic factors.
- Recent market actions have shown that during periods of market stress, Bitcoin has often sold off in tandem with high-risk assets, such as tech stocks, thereby challenging the idea that it’s an uncorrelated asset.
- Gold, on the other hand, has a millennia-long history as a store of value and has been less volatile relative to Bitcoin.
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Institutional Perspective:
- The sharp decline in Bitcoin’s price from 2020-2023 may cause hesitation among institutional investors. Like the analogy of a baby and a hot stove, institutions that faced significant losses during that period might be more cautious about re-entering the space or allocating significant capital.
- Gold is a well-understood asset among institutional investors, with well-established methods for valuation, storage, and insurance. Importantly, central banks around the world hold gold, including the US.
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Utility and Use Cases:
- Gold possesses inherent physical properties that give it utility beyond just being a store of value. It’s used in electronics, dentistry, jewelry, and various other industries.
- Bitcoin, being a purely digital asset, does not have such varied physical use cases. While proponents argue that Bitcoin’s main utility is its decentralized, borderless nature as a medium of exchange, critics point out limited adoption for everyday transactions and potential use in illegal activities. Furthermore, the centralized nature of the “crypto” exchanges crushes Bitcoin supporters’ argument of being Truly decentralized, as we have seen with the spectacular collapse of Luna Terra (LUNA-USD) and FTX.
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Environmental Concerns and Carrying Costs:
- Bitcoin’s proof-of-work consensus mechanism is energy-intensive, leading to concerns about its environmental impact. This, coupled with the halving events that reduce miner rewards and potentially increase the cost of mining over time, adds to the asset’s carrying costs.
- Gold also has environmental impacts associated with mining, but it doesn’t have the same type of “carrying costs” as Bitcoin. Once gold is mined, there’s no additional energy cost to maintain its existence or value.
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Perception and Sentiment:
- The public perception of Bitcoin is still evolving. While some view it as “digital gold,” others see it as a speculative asset or even a bubble. This varying perception can contribute to its price volatility.
- Gold’s perception, due to its long history, is more settled and generally accepted as a hedge against inflation, economic uncertainty, and currency debasement.
Risks
It’s essential to acknowledge the inherent risks in this pairs trading strategy. Unpredictable geopolitical resolutions could alter the scenario. A swift and peaceful resolution to either of the ongoing wars can dampen the projected inflationary pressures. Furthermore, innovations in energy sources or breakthroughs in energy storage could alleviate some of the anticipated energy-related inflation. Lastly, global central banks’ coordinated efforts or policy surprises can’t be ruled out, which could counteract some of the projected impacts on gold and US treasuries.
Conclusion
In summary, the pairs trade idea of longing gold and shorting US treasuries seems justified as we approach the end of 2023 and enter early 2024 and various geopolitical tensions. We believe the best vehicles (our core trade idea) to implement those trades are ETFs such as (GLD) and shorting 20-year US treasuries (TLT) or using levered inversed short ETF such as (TMV); more specific pros and cons of each of those vehicles are summarized above. Although we like the levered nature of gold miners (GDX) (GDXJ), we do believe the volatility may be too much for low-risk investors, and also, gold miners historically tended to trend with the general market (i.e., 2008 and 2020 crash), acting more like high-risk equity rather than acting as a “hedge.” For investors seeking instruments without leverage, we recommend (DTYS), which does not involve leverage or outright shorting 20-year treasury (TLT), (IEF), or (TLH) through a reader’s broker. We maintain our bearish view on cryptocurrencies (BTC), and we do not recommend investors substitute gold with bitcoin, cryptocurrency-related equities (COIN), or any other cryptocurrencies (ETC) for the reasons we described above. Net net, the ongoing wars involving major global players, coupled with potential inflationary pressures and a cornered Federal Reserve, all contribute to this investment rationale. However, as with all trading strategies, it’s vital to remain vigilant, continuously monitor global events, and adjust the strategy based on real-time data and changing circumstances.
