- Gold is extensively used as an inflation-hedge asset during economic downturns to protect investments.
- The short-term volatility in gold prices can degrade the value of gold, thus decreasing the value of an investment.
- Analysts also believe that cryptocurrencies like bitcoins can be used as an inflation-hedge asset.
Hedging is a risk management strategy that is aimed at protecting investments. The technique is used to mitigate various risks and to avoid the potential negative impacts.
The practice doesn’t prevent the investments from suffering losses. It only offsets the risk of losses from other assets.
Gold is considered as a hedging instrument, as the yellow metal lacks credit or default risks. The price of the yellow metal is inversely linked with interest rates. When the interest rates fall during economic downturns, the gold price shoots up.
Thus, we can say that the precious metal is a hedging instrument against a failing economy.
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The rise in the cost of goods and services over a period of time defines inflation, which is the expansion in the money supply in an economy. As a result of inflation, a higher amount of money competes for the same amount of goods and services, thus cranking up the prices.
Nowadays, central banks and governments can create currencies in larger quantities at a faster pace; however, it is not the same case with the production of goods and services. This increases the price of goods and services over time.
The rise in money supply in an economy has certain drawbacks like price inflation. Meanwhile, the rate of growth of our income doesn't match up with the rate of money supply in the economy.
Gold is widely used as a hedge against inflation. During economic crises, gold acts as a hedging asset capable of absorbing shocks in the bond, oil, and equity markets. The yellow metal is considered as a safe haven investment for preserving wealth over generations.
Good Read: Six Major Gold Miners with Massive Reserves
Silver along with few other metals and real estate are also considered as a hedge against inflation due to their intrinsic value as they are available in limited supply.
Which factors contribute to the volatile nature of gold?
The volatile nature of gold, in the short term, which can be a result of many factors, may degrade its value. Let us have a look at some of the most important factors that can drive gold prices.
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Central Bank Reserves: Many central banks across the globe hold gold and paper currency in reserves. As these banks diversify their monetary reserves, the gold prices rise. According to the World Gold Council, Turkey was the world leading gold buyer in 2019.
US Dollar Value: Gold prices are inversely linked to the US dollar. The gold prices go down with the rise in dollar prices and vice versa. As more gold can be purchased at lower dollar prices, gold prices go up.
Wealth Protection: During economic downturns or recessions, gold becomes a safe haven investment because of its enduring value. As the actual return on equities, bonds and real estate fall, the overall investment is directed towards the yellow metal. Gold is also used as a hedge against currency devaluation.
Investment: Investment in gold in the form of exchange-traded funds (ETFs), which hold the metal and issue shares that speculators can trade, is another factor driving gold prices. Some ETFs hold the ownership of actual metal while others may hold the shares in mining companies. With strong investment in ETFs, the prices may rise.
Production: The primary movement in gold or any commodity depends on the demand and supply statistics. The prices move up with limited supply and vice versa.
How does the yellow metal work as an inflation hedge?
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Inflation hedging helps to protect the value of investments. Some investments can provide decent returns; however, when inflation is considered as a factor, the overall returns can turn out to be negative.
However, inflation hedge assets are self-fulfilling. They keep their values high even when the intrinsic value is low. For example, the value of a dollar loses its value due to inflation while the value of gold remains protected even on falling dollars because inflation may dent the dollar’s value but the price of gold will rise in this case as more gold can be purchased at a lower dollar value.
Gold’s performance as an inflation hedge
The inflation hedge characteristic of gold is its unique and traditional selling point. As a tangible asset, gold holds its value, unlike dollar and paper currencies which lose their purchasing power with an increase in inflation. With rising inflation, the value of gold appreciates, thus it is a perfect inflation hedge asset.
However, several market experts have raised doubts on the yellow metal’s capability to hedge against inflation. Bullion has not performed up to the mark, as Treasury Yields gained more traction during the ongoing economic recovery phase. In the current scenario, many have considered gold as an inflation hedge against the dollar.
Bitcoin as an inflation hedge?
Though various market analysts believe that bitcoin is the new inflation hedge asset, its short history seems to be a roadblock in reaching any conclusions about its inflation-hedge capabilities. The cryptocurrency was created in 2009.
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As of now, there is not much clarity around inflation’s impacts on the volatility of Bitcoin. However, the value of the cryptocurrency has doubled from mid-December 2020 to January 2021, with the rise of inflation.
In May 2021, amid growing inflation concerns, the Federal Reserve signalled a rise in interest rates, as a result of which Bitcoin’s value declined as much as 41% to nearly US$38,000 from its peak value of US$64,800 in mid-April.