Investment management consultant MATTHEW FEARGRIEVE discusses the relationship between rising yields on US Treasuries and the fortunes of Gold and Bitcoin.
By 17 March the financial markets were clear about one thing: that the Fed intends to run the US economy hot.
At its 17 March meeting, the Federal Open Market Committee (FOMC) upped its inflation forecast from 1.8% to 2.4% for 2021, whilst simultaneously keeping interest rates nailed to the floor; the Fed has indicated that no rate increase is likely until 2023 at the earliest.
By raising its 2021 inflation target to 2.4%, in tandem with maintaining its commitment to a massive economic stimulus spending, the Fed has clearly signalled the US government’s willingness to tolerate a short-term rise in inflation as an acceptable price to pay for post-pandemic economic recovery.
And so, just at a time when the US government is issuing large volumes of government bonds (aka US Treasuries) to fund this spending, the spectre of inflation appears on the horizon.
The effect of these two things – more bonds in issue, plus the prospect of inflation eating away at the returns on longer maturity US Treasuries – has led to the recent surge in bond yields, by which investors demand higher returns to compensate them for the risk of inflation. These higher yields accordingly increase the cost of borrowing for the US government.
We suggested in our earlier piece Why Bond Yields will Climb Further that it would be unwise for investors to assume that the Fed intends this inflationary period to be purely transitory. More than a year of economic lockdown has left the world economy in need of massive stimulus and spending programmes to help it reflate. We know nothing about the extent of the Fed’s capacity to tolerate prolonged inflationary pressures before it will feel compelled to take normalising action. Raised levels of inflation could well be higher and longer-lived than we would prefer to believe.
The more real the prospect of a new era of inflation dawning, the higher bond yields will rise. The Fed has not shown itself particularly willing to curtail rising yields by buying back Treasuries. True, there is some repurchasing going on, but this is outweighed by the volume of new bond issuances as the US government pursues its goal of spending its way out of economic trouble.
Bond Yields & Gold
The world’s most trusted precious metal has had a bad start to the year. After mid-pandemic highs in 2020, vaccine roll-outs are now renewing investor confidence and the price of gold, a traditional safe haven in turbulent times, has fallen by 9.6% in US dollar terms over the first three months of 2021.
Figures released this month by the World Gold Council show that central bank gold purchases, one of the key drivers of demand, have tumbled in 2021.
Gold has suffered in part from growing optimism about the global post-pandemic recovery, but also from rising bond yields.
Higher yields on US Treasuries are bearish for precious metals because investors can earn guaranteed returns from the yield at lower investment cost (the bond price), unlike metals which fluctuate in price and do not generate any income (interest, dividends).
We think the 2021 challenge for gold prices is twofold: economic recovery and higher-than-normal bond yields, which will be attractive both to institutional investors, who can realise more income from US government debt than from precious metals, and to retail investors, who are already trimming their gold exposure in Comex and ETFs.
Read more: The Challenges ahead for Gold Prices.
Bond Yields & Bitcoin
Despite historical correlations between rising bond yields on one hand, and gold and Bitcoin on the other hand, Bitcoin is bucking the trend whilst gold sunk to a one-year low of US$1,678 per ounce on 8 March.
Following the conclusion of the FOMC meeting on 17 March, crypto investors watched nervously for an increase in Fed bond buyback activity, intended to curtail rising bond yields. Analysts had been warning that a fallout from bond yields could lead to a correction in riskier assets like Bitcoin.
Rising yields dilute the appeal of Bitcoin as a perceived inflation hedge just as much as they do gold’s. In February Bitcoin showed itself to be sensitive to bond yields, when prices fell by 20% after the US 10-year Treasury yield rose sharply to a year-high of 1.6% (this being some 2.3% higher than the yield on 10-year Treasury Inflation-Protected Securities, or “TIPS”, compared with a gap of just under 2% at the end of 2021; an increase that highlights market nervousness about inflation returning).
After the FOMC meeting, the 10-year Treasury note yield went higher, to 1.74%, as markets began to digest the Fed’s message that it was prepared to tolerate inflationary conditions for the foreseeable future.
There is an irony here. Just as inflation may escalate, once more consumers start spending again, and Bitcoin looks like coming into its own as an inflation hedge, it is rising Treasury bond yields that could create extra selling pressure for the cryptocurrency.
Indeed there was some Bitcoin sell-off between 17 March to month-end when the Fed showed itself to be reluctant to step in to curtail rising yields. Thereafter, though, Bitcoin prices rose again. Bitcoin bullishness seems so far to be immune to rising yields, helped no doubt by continuing institutional take-up.
There is a caveat to this bullishness. Bitcoin may face selling pressure if yields rise at a faster pace, which would destabilize stock markets. Gold, as a traditional, stable safe-haven, would benefit if the markets were spooked in this way. Crypto, as a risky asset, would not.
That said, a number of big market players (like Goldman Sachs) expect equity markets to be able to absorb a 10-year yield of around 2% without much difficulty.
During previous episodes of yield spikes, institutional participation in Bitcoin was lower and the cryptocurrency was largely an uncorrelated asset. Times have changed. So Bitcoin’s rise could indeed be unchecked by prolonged high yields.
Sell Gold and Buy Bitcoin?
We posited earlier in this piece that the challenges for gold for the rest of 2021 will come from continuing economic recovery and government bond yields staying high
We must consider a third challenge for gold – the rise of crypto as “digital gold”.
It may be that an additional dynamic driving gold prices lower is the increasing number of investors opting for crypto as digital gold – a digital hedge against inflation – instead of the precious metal, not only because of the higher upside potential but because crypto positions can be liquidated much more easily than physical or derivative gold positions.
Whilst the jury is out on whether rising bond yields will curtail the rise in Bitcoin prices, Bitcoin’s place as an increasingly important player in the macroeconomic environment may well help it to ride out the yield curve and consolidate its role as a hedge against inflation. This would enable it to eat away at gold’s market share.
We do not consider that this is the time to exit gold completely. The lingering whiff of inflation, combined with the potential for higher unemployment on both sides of the Atlantic once furlough schemes are withdrawn, are strong dynamics that tend towards retaining some exposure to gold.
And remember, gold could benefit from both a rise in bond yields and a drop. When US Treasuries pay lower returns, investors will trim their bond holdings and move money back into gold and other precious metals, which will drive prices up. Conversely, a spike in bond yields could give markets a big dose of the inflation jitters, and trigger a shift from the dollar to gold as a safe haven. This was seen in the 1980s when yields soared upwards toward 14% and gold also spiked. Bitcoin, still a risk asset, will not benefit from a flight-to-safety like this.
As for buying Bitcoin now; why would you? We do not feel that Bitcoin prices can go much further (although we were proved wrong about this in Q3 last year). The price surge is starting to have “bubble” written all over it.
In the absence of some significant crypto catalyst, such as legislation in the US that would facilitate a Bitcoin ETF, or a new large tech player entering the crypto economy (and, no, we do not consider the Coinbase IPO to be such a catalyst), there is, we think, little fundamental support for a new Bitcoin rally in the short term, particularly if recovery optimism is sustained and equities maintain their current levels of attraction for retail investors.