Gold traded at US $1,900 for the first time since January, after Federal Reserve officals talked down the “real” (CPI-indexed) yield of Treasury securities.

The market may not believe that inflation is transitory, as Federal Reserve Vice Chair Richard Clarida repeated once again Wednesday morning – but it believes that the Fed will stick to its story, because it can’t do anything else without a great deal of pain.

The Chart of the Day shows gold against its main competitor, inflation-indexed US Treasury securities (during the past year and half it has tracked the 5-year maturity most closely).

Gold and inflation-indexed Treasuries, or TIPS, serve the same function. They pay off big if there is a surge in inflation beyond what the market already has priced in. Over the long term, they trade pretty much the same way.

Of course, gold has some advantages over TIPS in periods of extreme stress. For one thing, the inflation measure that gauges the TIPS yield is the US Consumer Price Index, which has understated inflation drastically during the past few months.

With rents up 17% year on year and home prices up 13.3%, the CPI’s measure of shelter inflation is only up 2.1% year-on-year, to cite one egregious example among many.

The devaluation of the dollar, moreover, is another threat: The Treasury may pay you a higher coupon to compensate for inflation, but if the dollar is depreciating against other currencies, those coupons are worth a lot less to the foreigners who own about a third of all Treasury debt.

That’s why gold tends to do better than TIPS in periods of stress, and worse in periods of calm.

The three arrows on the Chart of the Day denote the TIPS-gold relationship in three different periods. The first is January-August 2020, during the worst of the COVID panic. That’s when gold outperformed TIPS, and the trend line shifted to the right. Gold was “rich” to TIPS.

The second arrow in the middle is August to December 2020, when the market began to price in a recovery.

And the third, on the left, is January through May 2021, when gold underperformed TIPS by a big margin. That’s starting to change, and there’s reason to believe it will keep changing.

For one thing, the dollar is falling, especially against the Chinese RMB. As we reported May 24, Chinese central bank officials have been saying that a strong currency is a buffer against imported inflation.

The offshore RMB traded Wednesday at about 6.38 to the dollar, the strongest level in three years. The trade-weighted US dollar index has fallen by 9% over the past year, and will continue to fall in face of the Fed’s impression of Groucho Marx: “Who are you going to believe, me or your own eyes?”

A falling dollar means more inflation.

It’s hard to tell from the chart above, but the changes in the dollar index clearly lead changes in the Consumer Price Index.

There’s more inflation to come. Bank of America analysts wrote to clients May 26:

While the rally in commodity prices, and the underlying drivers, may not have been a major focus initially, concerns have become more pronounced. This has also been mirrored by comments in the latest US Purchasing Manager Index Survey, with manufacturers apprehensive over both cost inflation and, linked to that, feedstock shortages. Taking a closer look into the dynamic, producer prices have already picked up, while consumer prices have lagged so far. That said, there is a high likelihood that wider inflationary pressures may not abate imminently. Indeed, a range of companies have been highlighting intentions to protect their margins.

The Fed will pretend that inflation is transitory, and the market will take the Fed at its word – and buy hedges against its inevitable failure. Gold looks like an attractive hedge at current levels.