How can an investor protect themselves against a US government default? Once, that was a crazy question to ask. But today the bizarre has become almost normal in American politics.
And while US president Joe Biden and House Speaker Kevin McCarthy have both indicated they want to cut a deal to raise America’s $31tn debt ceiling — and thus avoid a putative default — significant sticking points remain.
So Wall Street analysts are now furtively weighing the protection options as they grapple with this new tail risk.
Some, like those at JPMorgan, argue that “diversification is the best defence,” and urge investors to “consider currencies and precious metals like the Japanese yen, the Swiss franc, and gold [and] high quality international equities.” That sounds sensible.
However, others are more focused: RBC Capital markets last week suggested that “gold looks like one of the few likely candidates that would bear the burden of resulting market flows” from default anxiety.
And a survey from Bloomberg this week echoes this. Gold is the top safety choice for professional and retail investors, by a long margin, with 52 and 46 per cent, respectively, citing this.
That is followed by Treasuries, selected by 14 and 15 per cent of professional and retail investors (which sounds counter-intuitive until you realise that a default would spark a US recession). Bitcoin lags well behind in third place, followed by the dollar, yen and Swiss franc.
One hopes that this is all simply theoretical. But even if a default is averted, it is worth noting the answers. For one thing, it shows the degree to which eurozone leaders have failed to convince investors that their currency is a viable alternative to the dollar.
Second, this pattern is a nasty snub to crypto evangelists. After all, bitcoin was created as an alternative to the established dollar-denominated financial order. If most mainstream investors shun it when that established system is threatened with crisis, that does not bode well for bitcoin’s future.
But the third, and most interesting, point revolves around gold. A couple of decades ago, investing in this asset seemed bizarrely retro, given that it does not pay a return.
But this month the gold price has been trading close to an all-time high (unadjusted for inflation) of $2,069.40 a troy ounce, after rallying 20 per cent since November, and doubling since 2016.
More importantly, some subtle but striking shifts have recently occurred in its trading pattern. Traditionally, the gold price has been inversely correlated to inflation-linked long term Treasury yields. The reason is that they both can act as an anti-inflation safety hedge — but since bonds offer returns, they typically become more attractive when real yields rise.
However, since early 2022, that relationship has broken down: real yields have climbed, but the gold price has risen too. Why? Analysts at Bridgewater, the US hedge fund, say one big reason is that many central banks have recently been gobbling up gold because they want to diversify their reserves away from the dollar, following western sanctions on Russia after its invasion of Ukraine.
Indeed, data from the World Gold Council published this month shows that central bank purchases hit a record high in the first quarter of this year, after record annual highs in 2022.
And the Council’s Louise Street predicts that “central bank buying is likely to remain strong and will be a cornerstone of demand throughout 2023”. It is a striking reminder of how frustrated countries like China and Russia feel with the dollar-based order, even if they lack a viable alternative to this right now.
However, Bridgewater thinks that another factor driving the rally is that the past 15 years of quantitative easing and recent high inflation have left central banks and retail investors alike reaching for gold as a store of value.
“There has been a shift from investors primarily evaluating gold as an alternative to other dollar-denominated savings to increasingly evaluating gold as an alternative to the dollar,” Bridgwater notes, pointing out that the traditional correlation between the dollar and gold price has also recently broken down.
It is thus little wonder that investors — be they central banks or befuddled consumers — embrace gold as part of a hedging strategy against a US default.
Maybe this pattern will change with a debt deal. Indeed, the gold price has recently dipped slightly on McCarthy’s comments. And when America last faced a similar debt ceiling crisis in 2011, the gold price also rose — but then sunk after a deal was made.
However, I suspect that history will not repeat itself so neatly this time, given the concerns about inflation, the weaponisation of the greenback and the fact that America’s political dysfunction will not end with any debt ceiling deal.
The key point is that gold is now a good barometer not just of global instability, but of US dysfunction too. In that sense, there is poetic, albeit ghastly, symbolism in the way that Donald Trump, former president and a leading 2024 Republican presidential contender, has embraced the idea of default — from the safety of his own homes, which are (in)famously full of gold furnishings.