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THE VALUE OF INSURANCE

By Annaly Capital Management

How to value gold is an age old frustration. As every schoolboy knows, it yields nothing and so can’t be valued on cash flows. It has very little industrial use. There is, however, a natural human tendency toward the use of currency so gold is an obvious candidate for a rare, durable, portable, and transferable form of money. There is no printing press (or helicopter) for gold. Thus, throughout history, the yellow metal has been an indisputable store of value, including during periods of inflation like the 1970s. However, its price is volatile and has certainly managed to lose some money for investors over periods shorter than, say, a few decades. In the chart below, we illustrate the point by plotting the inflation-adjusted gold price versus the year-over-year change in Core CPI.


As inflation came down in the early 1980s, gold fell with it. The relationship between real gold prices and inflation seems to break down during the 2000 recession, where inflation began to decline but gold began a new bull market. Current real gold prices are back to levels not seen since 1980, when inflation was running at over 12%, despite current levels of inflation below 1%. Gold must be in a bubble, right?

Not necessarily. Another way to think about gold is as insurance against the debasement of the currency, and against future inflation. Insurance against policies that debase the currency is worth something, because a falling dollar erodes your global purchasing power just like inflation erodes your purchasing power at home. The next chart plots real gold prices against the US dollar index. The inverse relationship is easily spotted.

The dollar strength that we experienced throughout the late 1990s didn’t top out until the Fed got below 2% on the target rate in late 2001. The steep decline in the dollar coincided with the gradual walking down of the Fed Funds rate to 1% over the next 2 years, putting in a durable bottom for gold prices. The dollar has never recovered and has been bouncing along a bottom range ever since; your insurance against policy mistakes has paid off handsomely as real gold prices have since quadrupled.

However, gold as insurance is now a different value proposition than it was back in 2000. It’s more expensive, but it seems the risk of monetary blunders has also increased. There is no shortage of opinions about current gold prices (see Mr. T’s appearance on Bloomberg TV), but as UK-based money manager Jonathan Ruffer said: “There is now a tax on safety.”

Question: if monetary policy hasn’t been effective in generating inflation, what should it cost to insure against it?