With Bond Yields Under Pressure and Inflation Persisting, Investors Are Turning to Gold
Key Takeaways
- •The 10-year Treasury yield rose sharply from about 1.5 percent in late 2021 to nearly 5 percent in fall 2023 and has stayed elevated since then.
- •Inflation has remained above the Federal Reserve’s 2 percent target, and the article says recent oil-price shocks have renewed price concerns.
- •Several strategists and firms are trimming bond exposure and shifting more capital into gold, commodities, real estate and infrastructure.
- •Central banks have increased gold purchases, and the European Central Bank said gold has overtaken Treasuries as the world’s top reserve asset.
- •The article calculates the 10-year Treasury’s real yield at about 1.1 percent using a 4.6 percent nominal yield and 3.5 percent CPI.
With Bond Yields Under Pressure and Inflation Persisting, Investors Are Turning to Gold
Mike Maharrey
The bond market has been under strain for more than a year, and some analysts say it may be in the early stages of a secular bear market. That backdrop is pushing investors to reconsider the role of bonds in a balanced portfolio, with some moving toward tangible stores of value such as gold.
Over the past two years, long-term bond yields have faced persistent upward pressure. The 10-year Treasury surged in 2022, climbing from around 1.5 percent in late 2021 to nearly 5 percent in the fall of 2023. Since then, yields have remained elevated even as the Federal Reserve cut rates and geopolitical events unfolded that would traditionally have generated strong safe-haven demand for Treasuries.
Reuters recently reported that “inflation, heavy government borrowing, policy uncertainty and bouts of stocks and bonds falling in tandem have weakened bonds' role as a ballast, prompting some investors to look for more diversification.”
Osaic chief market strategist Phil Blancato told Reuters that bonds function as portfolio insurance only when inflation is low. He said the wealth management firm has reduced its fixed-income allocation from the traditional 40 percent to 31 percent, while assigning 6 percent to commodities.
Inflation is clearly not low. It has remained well above the long-standing 2 percent target for years. Although the Consumer Price Index had eased in recent months, the oil shock tied to the U.S.-Iran war has renewed concerns about price inflation.
More broadly, the money supply has been rising for more than a year, and despite public commitments to defeat inflation, the Federal Reserve is currently expanding its balance sheet through a modest quantitative easing operation. By definition, that is inflation.
Last year, Morgan Stanley CIO Michael Wilson suggested a more aggressive portfolio shift, recommending that investors cut their bond allocation to 20 percent and move half of the bond portfolio into gold as a more resilient inflation hedge.
“Gold is now the anti-fragile asset to own, rather than Treasuries. High-quality equities and gold are the best hedges.”
Northern Trust analyst Grant Johnsey also told Reuters that persistent inflation, a weakening currency and bond supply outpacing demand are eroding bond returns over the long term.
“Many investors are worried that one or more of these variables will play out in the coming years. The issue with the bonds is that when you go out past five years, there are too many potential downside headwinds and not enough tailwinds behind it.”
That view highlights why real interest rates matter when evaluating investments. Conventional wisdom says higher inflation leads central banks to tighten policy, pushing interest rates higher. Higher rates are often seen as a headwind for gold because it does not generate yield. But inflation can compress the real rate even when nominal rates rise, which is why investors watching bond returns are also watching the inflation-adjusted picture.
In simple terms, the real interest rate is the quoted rate adjusted for inflation. To calculate it, subtract CPI from the nominal yield. The result shows how much purchasing power an investment is actually expected to produce over time.
For example, the 10-year Treasury is currently yielding just over 4.6 percent. That may appear attractive at first glance, but with CPI running at 3.5 percent, the real interest rate on a 10-year Treasury is only 1.1 percent, based on 4.6 minus 3.5.
As CPI rises, that real rate falls further.
Sagard Wealth Management CIO Stephen Harvey described the current backdrop as “pro-growth and pro-inflation” and said fiscal policy now matters more than monetary policy.
In practice, that means investors are paying less attention to what the Federal Reserve and other central banks may do with interest rates and more attention to the heavy borrowing and spending by governments around the world, especially in the United States. Given what Harvey characterized as America’s fiscal malfeasance, many investors have become reluctant to lend more money to the U.S. government. That reluctance has become one of the key pressures on the bond market.
Harvey said Sagard is steering investors away from developed-market fixed income assets and into a “preservation bucket” that includes commodities, gold, real estate and infrastructure. He described fixed income as “the inflation loser.”
Central banks are also moving away from Treasuries and increasing their gold holdings. Earlier this year, the European Central Bank confirmed that gold has surpassed Treasuries to become the world’s top reserve asset.
Last year saw the fourth-largest expansion in central bank gold reserves on record at 863 tonnes. That was down 21 percent from the prior year, but still well above the 2010-2021 annual average of 473 tonnes. The record remains 2022, when central banks added 1,136 tonnes, the highest level of net purchases on record dating back to 1950 and including the period since the suspension of dollar convertibility into gold in 1971.
State Street global market strategist Jenn Bender told Reuters that “real assets, tangible assets valued for their intrinsic physical qualities,” have gained appeal since the post-COVID inflation shock. She said the case has strengthened further as “the bond outlook clouds and soaring equity markets appear vulnerable.”
“The worry is that there is some downside risk in equities. Fixed income is not the place that people want to move their equity allocations over to. Basically, real assets is kind of where you end up.”