Investors generally misunderstand gold. It is not a hedge against inflation, not, at least, against the sort of inflation we see in store prices. This becomes clear when we compare the gold price to the two components of the 10-year Treasury yield, namely the yield of inflation-indexed Treasuries (TIPS) vs the so-called breakeven inflation rate, that is, the yield difference between ordinary coupon Treasuries and TIPS.

We observe almost no relationship between gold and breakeven inflation expectations embodied in the 10-year yield, but an extremely close relationship between gold and the inflation-protected Treasury yield.

Exhibit 1: Gold vs 10-year TIPS (left-hand scale) and 10-year break-even inflation (right-hand scale), daily data from February 2, 2006 to February 2, 2012

Source: FRED, World Gold Council.

The r-squared of regression between gold and TIPS yields during the past five years is a remarkable 87%. Between gold and breakeven inflation, it is zero. Nonetheless, economists, commentators and financial advisers insist on referring to gold as an inflation hedge.

We find a solution to the puzzle when we cease to view expectations as a fixed point but rather as a range of possibilities. Gold is not a measure of the future price level, but an undated, out-of-the-money put option on the US dollar’s reserve role. Bonds (especially inflation-indexed) are an option on prospective inflation.

The fact that the value of both these forms of optionality is rising tells us that markets are extremely uncertain as to whether we will have inflation or deflation. Investors pay up for hedges on both. That is the theory; empirical observation strongly supports the textbook.

The market is suffering from something like Margaret Dumont’s double blood pressure in the Marx Brothers’ classic A Day at the Races. Fiscal strains in most of the major industrial countries might lead to inflation on the Latin American model, or deflation on the Japanese model.

Deflation can arise from fiscal strains when governments are unable to borrow and are forced to cut expenditures drastically, for example, the southern European countries in the context of the European Union. If these countries leave the eurozone, revert to their old national currencies, and turn on the printing presses, the result could well be inflation.

The 10-year inflation-indexed Treasury pays a negative yield of 40 basis points. If inflation remains where it is now, investors get back less principal than they invested. They are willing to buy into a loss in order to be insured against an unexpected jump in the inflation rate.

Gold tracks TIPS much more closely than coupon Treasuries, because it also represents an option on inflation.

Investors suffer from one-dimensional thinking; the market is not betting on a specific score, but rather on the point spread. The risk of an extreme change in the value of money motivates investors to pay a negative yield to own TIPS, and to own a sterile asset in the form of gold.