Andy Constan Profile picture
Apr 29 19 tweets 4 min read
Gold 101 $GLD #GOLD
This is my framework for gold. It may be different from most.
Gold has two purposes
1. For consumption in jewelry, decorative and industrial use
2. As a currency and store of value

Number 1 makes gold a commodity. I'm going to ignore this purpose

2 is big
Two important things about gold as a currency is that for these purposes has a fixed quantity and it pays a negative interest rate. That negative rate is the cost of storage and protection.

Let's start with the negative interest rate. We can compare any other currency to gold
On this basis alone. Fiat offers a positive interest rate in most circumstances. This is a downward pressure on gold and also explains partly while the change in real yields can be inversely correlated with gold. Essentially it's the interest rate differential often discussed
In fiat currency pairs

The other basic understanding that one can use for gold is that is a fixed quantity currency and fiat can be created out of thin air by the credit creation process. Read my banking 101 for details. So another way to think about gold is it
directly correlated to the amount of money and credit in the global economy. As the amount of money and credit could be rising regardless of the level of real rates. So given both of these forces can be moving in different directions or the same direction gold prices can be
Correlated to one or the other or both depending on how large each is changing

Another important aspect of gold is that it is perceived as an inflation hedge. This is often confused. Let's start by focusing on the second part of the framework above. Gold is very effective.
As an inflation hedge when monetary "devaluation" is the driver of inflation. Let's use a simple example. If for instance all of sudden every USD was ripped in half and was allowed to be used as if it was a full dollar. All goods prices would double as would gold. While each
Individual dollar would only buy half a widget gold would be able to buy a full widget. In other words gold would maintain its purchasing power. Because fiat is regularly increased in supply that generates a higher goods price and gold keeps up with inflation. That ability to
Maintain purchasing power in monetary inflationary times is a major reason to own gold. Of course investing is a game of anticipation of future conditions gold can rise with expectations of monetary driven inflation. However, two others drivers of inflation are less reliable
Drivers of gold. If supply chain disruptions cause less goods to be available goods go up in price. But there is no particular reason for gold to go up Vs fiat. So in supply chain disruption driven inflation gold is not a hedge. A slightly more complicated case is when demand
Drives inflation. I want to differentiate demand driven inflation when demand is driven by money and credit rising vs demand driven by other factors. To keep them separate consider this example. Imagine a world with a fixed quantity of money and credit with a variety of poeple
Who hold that money. Let's describe two classes of people thrifty and spendthrift. If for some reason (like for instance labor getting leverage over ownership) people shift from thrifty to spendthrift that generate more immediate demand and thus higher prices. Once again gold
Has no particular driver to rise vs fiat and yet goods inflation occurs. In this example gold again fails as a hedge to inflation.

So notice gold rises when money and credit rise, gold rises when real interest rates paid to fiat fall. What else drives gold. Fiat collapse.
I mentioned that gold rises as money and credit rises. But a fiat collapse is a convex version of this relationship. All classic fiat collapse result in exponential devaluations. Imagine the cutting in half of the bills above followed by successive halvings gold retains its
Purchasing power the whole way. Because this tail risk is option like in payoff. Gold today has convexity. In other words there is a call option on fiat collapse. This embedded option is probably well out of the money. But it's implied volatility (or probability of a tail event
Can shift rapidly. In particular when central banks "credibility" shifts. I put "credibility" in quotes because when you deal with gold people get emotional. Regardless of what you think about the level of credibility, you can at least understand the level can become more or less
Credible. That shift generates shifts in the both the level of expectations of future monetary growth and the volatility of those expectations which in turn impacts portion of gold price that I believe is best characterized as option premium
That's what I got.
Gold changes when real rates change, money and credit change, and probability of fiat collapse. Gold can be a hedge to inflation but only when one of the drivers of gold is driving the price of gold. Supply chain ain't gonna work, Wage inflation demand
Ain't gonna work. Money and credit falling out of the sky. That'll do it.

Stepping back expectations matter and all these things happen at once.

P.S. one fiat can be different than other fiats or they can be similar. The fact that gold is "denominated" in USD is irrelevant

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