Inflation, Deflation And Gold

There's an old saying in the newspaper business that dog bites man is not news, but man bites dog is. This observation still holds true even under today's faster and looser standards of journalism.

By this standard, the gold market may be getting ready to give Fido a hefty chomp on the shins by rising in what is alleged to be a deflationary environment. Let's look at some key quantitative indicators of the gold market, including the inflationary expectations embedded in the bond market, the dollar and gold lease rates.

Two principles are important here: First, the price of any physical commodity will rise if the expected rate of inflation exceeds the costs of holding it. Second, the price of any physical commodity will rise in a given currency if that currency becomes worth less.

TIP-Toe Through The Minefield

If deflation is about to become a scourge upon the land, the Treasury note market appears relatively unfazed by the prospects. We can compare the yield spread between two notes of near-equal maturity, the 6.50% note due Feb. 15, 2010, and the inflation-protected 4.25% TIPS due Jan. 15, 2010.

While the maturities are nearly equal, their risks are not: the 6.50% has a modified duration, or percentage-price change for a given change in yield, of 5.52, while the 4.25% has a modified duration of only 2.86. You would need to purchase 10,000 TIPS to have a risk-adjusted position equivalent to 4,994 conventional notes.

This is the opposite of the expected relationship for conventional bonds in which the lower coupon bond would have the higher duration and is due to the mechanics of TIPS. The principal to be repaid on the TIPS is adjusted on a daily basis for changes in the urban consumer price index, which gives current holders an accelerated claim on cash flows. In addition, if we're headed into a deflationary environment, the Treasury will make up the difference between $100 and the deflated price of the TIPS. In option terms, the TIPS investor has both a call option on inflation and a put option -- a straddle -- on deflation simultaneously.