Posted by Eddie van der Walt, Bloomberg Macro Commentator
Even when hedge funds have a range of risk protection products at their disposal, such as a short S&P 500 position or long volatility volatility, many still buy gold. What for? Because it offers broad protection against the unknown, and not targeted insurance against identified risks.
In the darkest days of March, the estimated metal market fell along with stocks and other risky assets as investors rushed to liquidity short-term treasury bonds. Even if you forgive this failure, it is a dumb tool compared to other forms of portfolio insurance.
However, the price of gold reached an eight-year high above $ 1,800 per ounce. Investors in exchange-traded funds have created a reserve large enough to provide global demand for gold for three quarters of a year. And celebrities such as Paul Singer, David Einhorn, and Crispin Odee have told patrons that they are bullish.
The first reason is usually feedback from real bets. As a non-profitable asset with the supposed qualities of inflation protection, gold tends to succeed when central banks turn blue in the face of slow growth. But there are more accurate ways to achieve this, for example, using inflationary swaps.
Such trading will present counterparty risk, which is the second excuse often quoted for gold. But if we are not talking about the collapse of the global financial system, these risks can be overcome with the help of collateral and clearing houses.
Instead, it is simply gold as a tool that makes it useful. It offers extensive insurance against the unknown, while a credit default swap offers protection against a very specific event.
This can be illustrated by how it moves relative to other assets. In ordinary times, the best explanation for the movement of gold on ticks is the dollar, whose correlation is -0.5 from the beginning of the century.
But it is not stable over time. During periods of acute stress, especially if stress is perceived as outside the United States, gold and the dollar can move in tandem. In fact, gold often takes the opposite side of the largest perceived risk factor in global markets.
Oddly enough, during periods of increased uncertainty in the eurozone, including the sovereign debt crisis and then the referendum to save Greece in 2015, there were stronger than usual feedbacks between the euro and gold valued in this currency.
This was the same case with the pound during the Brexit vote when the mathematical relationship between the pound and the bullion priced in pounds changed from a 10-year average from -0.2 to -0.84.
And it works at the statistical level too. For major stock indices and the most liquid currencies, the correlation between gold and the counter asset becomes more inverse when the volatility of another asset increases.
The table below shows the average correlation with gold in changing volatility modes, with data from the last two decades compiled by Bloomberg on a 60-day moving basis. For currencies, cross-correlation was measured to gold priced in that currency.
This shows that the nature of the protection of gold changes as risk factors change. Concerns shift from trade wars to geopolitics and hyperinflation, and gold offers universal protection that is difficult to achieve with short positions against the S & P 500.
Therefore, in the world of ultra-fast coronavirus, it is not surprising that hedge funds still love gold.