Wider Credit Spreads Favor Gold

Gold is the ultimate safe haven because it is no one else’s obligation. It isn’t issued or backed by any government, central bank or corporation so the value of the gold you own is completely independent of anyone else’s performance or lack of it. When you own a bond, its value is dependent on the creditworthiness of the issuer. You don’t really own an asset, you own their obligation to you. When you own a stock, the value is dependent on corporate performance and whether or not management meets its obligations to you as a shareholder. Stocks aren’t assets, they are paper promises.

Gold Mine

None of this matters until it does. As long as markets have confidence in everyone keeping their promises, paper obligations trade like assets. When confidence wanes, stocks and bonds start to look like paper, investors start looking for safety and they start to bid up the price of gold. That’s what is happening now.

How do you know when investors are starting to run from risk towards safety? The clues are in the credit market. When investors are confident that promises will be kept, they bid up the value of the debt of weaker companies, reducing the interest rate spread between their paper and the debt issued by stronger companies. When confidence wanes, credit spreads widen—the debt of weaker companies goes down against the debt of stronger credits.

One easy way to measure credit spreads is to look at the ratio of low quality debt to high quality debt. The trading history of two ETFs gives you the data—HYG for the poorer stuff and LQD for the better stuff. Below is the one year daily chart on the ratio. This is one of the reasons gold has broken out to the upside.

Gold Chart