Not all safe haven assets are the same: The case of Gold (and Bitcoin?)
Panics and crashes lead investors to hunt for safe haven assets such as bonds, gold, and maybe Bitcoin. But it’s complicated so be careful!
As the onslaught of the coronavirus continues to march worldwide and achieves pandemic status, many financial portfolios also continue to be caught in the turmoil. Markets are a constant push and pull between fear and greed, and in the past few weeks, fear has taken a front seat across asset classes. This marks a sharp shift from the start of the year when volatility was low, and the stock market was making new record highs regularly. Although the immediate cause of the collapse in prices is the coronavirus, many troubling signs were building up for global economies before the virus. China, Europe, and many emerging market economies were slowing for months, and various global metrics from shipping to speculative debt were displaying warning signs. One of the enduring legacies of the 2008 crisis is the hunt for “safe haven” assets where investors can park capital or even profit when turmoil engulfs risk-loving markets such as equities.
What is a safe haven asset? Safe haven assets tend to display negative correlation to mainstream risk assets, especially stock indices, especially during periods of market decline. So such assets are expected to rise in value when the S&P 500 has violent declines. As with most market jargon, the idea of a safe haven asset is vague, and many markets get lumped in as safe havens even though they behave in a varied manner during periods of turmoil. The common safe haven assets can be largely grouped into two groupings:
- High quality sovereign bonds such as Treasuries, Japanese Government Bonds, German bonds and related FX markets (Yen, Swiss Franc)
- “Hard money” assets such as gold, other precious metals, and a possible new contender, bitcoin
While these safe havens are discussed as a basket, their behavior during panics can vary substantially, and especially in the case of gold or bitcoins, there is considerable misinformation or misunderstanding about how they may behave in times of turmoil. The reaction of bonds and FX during crisis events is a topic for a separate post, and here we will discuss the safe haven status of gold and bitcoin during market panics.
For an asset like gold, its value during times of crisis stems from the fact that it has been a relatively reliable store of value for millennia. Bitcoin has a much younger, unproven history, but with a mathematically fixed supply, there is an increasing belief of bitcoin being a digital store of value in conjunction with gold. This characteristic of limited supply and perceived store of value presents a degree of safety during times of rising uncertainty, driving capital flows towards these assets during crises. In the case of gold, this feature of demand has been repeatedly reinforced over thousands of years, while in bitcoin, this demand is still in its formative stages with varied reactions to stock market drops in recent years. However, even for gold, behavior during crises is not a straight line up. Even as risk assets drop, sometimes gold will have sharp declines in the midst of the panic such as during the fall of 2008. This often leads to a broad range of opinions from blaming algo traders to conspiracies about central banks holding down the price. The real explanation tends to be in a far more mundane area of the market: the use of gold and other non-interest bearing assets as collateral for borrowing.
Collateral for Borrowing
In real estate, the saying is it’s about location, location, location. When panic hits financial markets, they undergo a phase shift where the factors that matter suddenly change. During crisis events, the corresponding saying would be collateral, collateral, collateral. Collateralized lending forms the backbone of our modern capitalist system. Repo markets and other such markets form large network of collateralized lending whereby one party pledges an asset to borrow cash. Gold has a similar, very large market involving lending out gold collateral in return for cash. Since gold does not earn interest, this lending activity helps large holders of gold like central banks and commercial banks earn income on their holdings. This use of gold as universal global collateral causes conflicting reactions between the build-up to a panic versus actual panic. This is because one of the key hallmarks of a market panic is a shortage of cash to cover obligations such as interest payments, and a last resort way to raise cash is to lend out high-quality assets like gold. The cash panic can be seen in repo market activity data such as a spike in fails whereby counterparties default on their obligations to return the cash they borrowed previously or in extremely high demand for superior collateral like Treasuries. During times of crisis, such activity causes an extreme bid for cash resulting in excessive lending out of high-quality assets such as gold.
This tug of war between the bullish traditional safe haven bid and the bearish force of increased lending supply to raise cash causes gold and similar ‘safe haven’ assets to have extremely schizophrenic movements during panics with sharp rallies when the safety bid is dominant but then sharp declines when the collateral issue dominates. The clearest demonstration of the above dynamic was evident during the depths of panic, the reaction of gold often turns and it sells off. This was clearly evident in 2008 — as the chart shows, gold rallied as the Bear Stearns bankruptcy loomed but going towards the Lehman event, the price of gold actually sold off. It was not until December 2008 that gold resumed its rally leaving one to wonder why this “safe haven” asset lost value during one of the worst panics in recent memory.
This oscillating dynamic has been on display during the Coronavirus episode as gold has been steadily rising towards $1700/oz but the last couple days have seen sharp declines heading below $1600/oz even with the large stock market drop. A likely culprit is rising demand for borrowing cash using gold collateral dominating the safe haven bid.
The effect of collateralized lending on markets is not often discussed, and outside of bond market participants, few others watch these effects closely. During the commodities meltdown of 2014, many commodities such as nickel witnessed much larger short term drops than their supply/demand dynamics would indicate, and the primary reason was their use as collateral in borrowing, which led to negative feedback loops of selling to raise cash. Often, fundamentally-oriented traders will lament volatility during such times as nefarious actions by “algos,” but often, it is the borrowing crunches that are far more to blame.
Will Bitcoin Be a Safe Haven?
Bitcoin has had far fewer chances to demonstrate such demand since it was not around in 2008, and even during the December 2017 market drop, it sold off while gold rallied showing that BTC still has work to do on the safe haven front. Some features of BTC mimic that of gold, in terms of relatively limited supply and easy storability and thus can be a candidate for a possible safe haven asset in future crises. However, a year is an eternity for Bitcoin, and recent behavior has been increasingly indicative of some safe haven asset features. For example, the relative stability of Bitcoin, or at least reduced volatility compared to average, even with the unprecedented stock market decline from record highs during this Coronavirus selloff indicates a build-up of the safe haven narrative.
However, as BTC matures as an asset class and starts to develop more active lending markets to earn interest for large holders, then investors should expect similar oscillations that gold goes through during panics. There will be periods of sharp price declines as BTC lending to raise cash, although they may not be synchronous. Unlike gold, it is not the central or commercial banks who are the major holders of BTC which makes deciphering cash crunch situations more difficult. However, as interest rate curves on BTC lending and borrowing develop, such activities will become more transparent. In the meantime, investors need to be very careful with their expectations of BTC price behavior during panics, even if they buy into the safe haven asset thesis.