Issue 82
A Golden Opportunity: Desperation, Disinflation and Debt
Almost a decade on from the global financial crisis, central banks around the world continue to resort to ever more unconventional monetary policies in order to stimulate economic growth. Having pursued successive rounds of quantitative easing, fiscal stimulus and interest rate cuts, several major economies now have nominal interest rates at zero or even in negative territory. Adjusted for inflation, many more have negative real interest rates, while central bank measures to buy up government debt have pushed yields on sovereign bonds ever lower – increasingly into negative territory. In this topsy-turvy world of negative interest rates, where financial institutions pay to deposit funds with the central bank and borrowers get paid, and where holders of government debt can sit on guaranteed losses, the canard that gold has no yield is turned on its head. The advent of negative rates presents a ‘golden opportunity’ for non-interest-bearing assets such as gold, and increasingly silver, to shine.
Desperation: negative rates becoming the norm
Negative rates for commercial institutions’ deposits at central banks were introduced in Sweden in 2009, and later in the eurozone in mid-2014, as a way to stimulate corporate lending and ultimately to raise inflation. Japan followed in January 2016 with the introduction of a -0.1% policy rate with much the same objective, and the European Central Bank (ECB) extended its negative interest rate policy in March of this year, moving its deposit facility rate to -0.4%. Denmark has had negative rates since 2012 and Switzerland since 2014, albeit their aim is to prevent a loss of competitiveness by keeping their currencies subdued relative to the euro rather than to specifically raise inflation and growth. Even US Federal Reserve Chair Janet Yellen has said publicly on a number of occasions this year that the Fed would not rule out the use of negative rates – the markets may partly believe this, with increased bets on rates falling to zero according to the Fed funds futures market.
Generally, each episode where interest rates have been moved into negative territory, or when negative rates have been talked about by central banks, has been accompanied by an increase in risk hedging in gold – as evidenced by growth in ETF holdings and an increase in gross long speculative futures positioning. The message that negative rates send to the markets is essentially one of desperation – that central banks are almost out of policy options. With this one last bullet left in the chamber, the ECB and Bank of Japan (BoJ) hope to achieve what all their other expansionary policies have so far failed to do – to lift growth and inflation. This is perhaps why central bankers are keen to emphasise the limitless possibilities of negative rates. In an echo of Mario Draghi’s ‘whatever it takes’ sentiment, BoJ Governor Kuroda has recently stated that there is no quantitative limit to negative rates, thus keeping the door open to more rate cuts. Further moves into negative territory are likely within this year – particularly in the eurozone, where the UK’s decision to leave the EU has created economic and political uncertainty – further eroding confidence in central banks’ ability to muster the desired results.
“Further moves into negative territory are likely within this year – particularly in the eurozone, where the UK’s decision to leave the EU has created economic and political uncertainty. “
An additional factor in the minds of some investors is that central banks could lose control of events by pushing rates ever deeper below the zero bound. Both the BoJ and ECB themselves, as well as the Bank for International Settlements (BIS), have publicly expressed disquiet about the potential distortions created in the banking sector by negative interest rate policies. A great deal of uncertainty remains about their longer-term consequences – whether they will be highly inflationary or, perversely, may make some institutions less willing to lend by squeezing margins and therefore could ultimately reduce liquidity. Mindful of these uncertainties, some investors may be positioning for the tail-risk event of inflation increasing significantly by adding gold to their portfolios. An uptick in inflation could see gold reassert its role as an inflation hedge, and if real interest rates are therefore pushed further into negative territory, the opportunity costs of holding gold could be kept extremely low. It is probably not surprising, therefore, that as well as gold ETFs and futures doing well from institutional investor flows so far this year, there has been a very buoyant market for gold in the retail space, particularly in regions where there is an historic sensitivity to inflation, such as Germany and the UK. Negative interest rates have not yet been passed on to households or business deposit accounts but if these policies were expanded, gold could pick up further demand as potential savers look for alternative ways to store their wealth.
The aim of encouraging greater lending by negative interest rates speaks to another aspect that in the longer term is likely to be positive for gold – the massive increase in levels of public, private and corporate debt since 2008. The world’s four largest economies, the US, China, Japan and the eurozone, all have total debt to GDP ratios (including public, private and corporate debt) approaching 250% or above. While there is some controversy over precisely what level of debt triggers a financial crisis, public debt exceeding 90% of nominal GDP is generally associated with lower economic growth. With debt at unprecedented high levels, it is very likely that interest rates will have to be kept ‘lower for longer’ until major economies deleverage – though how successful this will be in an era of cheap borrowing remains to be seen. To use a well-worn analogy, it will be even more difficult for central banks to ‘take the punchbowl away from this party’.
Disinflation
There is however a problem with negative rates in that, so far, they do not appear to be having the desired effect of weakening local currencies relative to the dollar in order to help import inflation and make exports more competitive – in fact, the opposite has largely been true. Between the announcement of negative rates in Japan in late January 2016 and the end of June, the yen actually appreciated by 15% relative to the US dollar. Similarly, the euro gained against the dollar in the weeks following the move of deposit rates deeper into negative territory. This has generally made imports cheaper, further fuelling disinflation (falling inflation). Markets seem to be betting against negative rates being sufficient to depreciate local currencies – investment inflows into the Japanese yen in particular, a traditional safe-haven currency, make it more likely that the BoJ will have to redouble its efforts to weaken the currency. Negative rates could therefore be with us for a while yet. If the yen does eventually succumb to weakening relative to the dollar then investors will be left with fewer safe-haven assets to choose from. As gold and silver are largely free of political intervention/manipulation, this makes them look more attractive.
A further threat from negative rates and eventual currency weakening by developed market central banks is that emerging market currencies look overvalued, resulting in a competitive devaluation of currencies such as the Chinese RMB, which happened in late June when the yuan was guided down to new six-year lows against the dollar. While this sort of ‘currency war’ may drive some flows into gold as an intervention-free asset, a more meaningful impact on bullion is that it reduces the likelihood that the US will raise interest rates any time soon – as the RMB and other emerging market currencies fall relative to the US dollar, imports into the US get cheaper, fuelling domestic disinflation. While raising inflation is the specific aim of many central banks’ ultra-loose monetary policy, disinflation, or falling inflation, continues to be a more significant threat, as does its even more insidious twin, deflation or negative inflation, particularly in the eurozone and Japan. Part of this is due to low energy prices thanks to oil market oversupply, which is likely to continue at least until OPEC’s semi-annual meeting in December 2016. Even stripping out food and energy costs to give ‘core’ US inflation – on a measure such as core personal consumption expenditure as used by the Fed – it is still well below the Fed’s 2% target. While low or falling inflation is not positive for gold as a traditional inflation hedge, what it does mean is that if inflation remains below target, the Fed will find it difficult to raise interest rates – even if it wasn’t already facing challenges from disappointing employment data, and wider macro and geopolitical concerns. Implied longer-term US inflation is also close to rock bottom, according to TIPS break-evens (the difference between inflation and non-inflation linked yields). As inflation is one half of the Fed’s dual mandate, too-low inflation means that interest rates will remain even lower for even longer, which means the low opportunity cost for holding gold as an investment and the favourable yield environment for gold should continue.
“A further threat from negative rates and eventual currency weakening by developed market central banks is that emerging market currencies look overvalued, resulting in a competitive devaluation of currencies such as the Chinese RMB.”
One consequence of expectations of lower for longer interest rates is of course that Treasury bond yields have been heading lower, improving the overall yield environment. However, However, 2 and 10-year US Treasury yields have been converging (see chart 2)– effectively flattening the longer-term yield curve, which is currently at an historically narrow gap of less than 100 basis points. The last time the market went so risk-averse was in early 2008 just before the global financial crisis. This has mixed implications for gold and probably negative implications for silver as an industrial metal. Although it is far from a concern at present, inflation (the desired outcome from all the monetary stimulus policies) will eventually re-emerge, and will be welcomed by the Fed as a way to reduce the country’s debt burden – with it, there will be a role for gold and silver as inflation hedges.
“The current pricing in of no US rate rises in 2016, and even the possibility of a rate cut, is more of a knee-jerk reaction to the shock Brexit vote and its implications.”
Debt market distortion
Successive waves of quantitative easing and now negative nominal rates have pushed down sovereign debt yields – as governments buy up their own debt, prices are raised and therefore yields are lowered. This has been intensified by recent investor flight to safety/quality assets amid the fallout from the Brexit vote. According to Fitch Ratings, there is almost $12 trillion worth of sovereign debt in the market giving negative yield. Any eurozone or Japanese debt with maturity of less than 10 years now has sub-zero yield, and longer-dated maturities are increasingly tipping into negative territory – meaning that investors holding that debt to maturity will sit on guaranteed losses. This makes non-yielding gold and silver look even more attractive to institutional investors. With 10-year US Treasury yields at record lows below 1.5%, thanks to a wave of safe-haven inspired buying and shorter-dated Treasury yields heading ever lower, investors may look to diversify into other safe havens. Although this dash to the safety of sovereign bonds can swing the other way quite quickly on changes in market sentiment, the pile of negative yielding debt will be around for some time yet and may result in greater risk-taking among financial institutions such as insurance funds to guarantee income and offset long-term liabilities.
Since asset purchases of non-bank corporate bonds by the European Central Bank began in June 2016, quantitative easing can be expected to push down yields on corporate debt in a similar way, which may force investors into higher-risk debt with longer maturities. There are signs that pension and insurance companies and investment managers are going in search of yield in more risky forms of debt, such as high-yielding (i.e. junk) corporate bonds. Some of this high-risk debt needs to be hedged, and a suitable hedge instrument can be physical gold, which should continue to support inflows into gold ETFs and gross long positions. If the ECB eventually begins its long-awaited policy of outright monetary transactions (OMT), whereby it buys up short-term sovereign debt from distressed eurozone economies in potentially unlimited amounts, there could be even more risk hedging in bullion.
Conclusion – Lower for longer
As of mid-2016, the market is pricing in a high probability of US interest rates remaining ‘lower for longer’, with a more than 80% probability of the Fed funds target rate not being lifted from its upper bound of 0.50% at any point within 2016, according to the futures market. This dovish outlook has turned on the result of the UK referendum, with the decision of Britain to leave the EU presenting a great deal of uncertainty for the markets for the next few years. Indeed, Governor of the Bank of England Mark Carney recently warned that UK rates may be cut from their record low of 0.5%, though separately he has warned against moving rates into negative territory. These expectations of no nominal rate rises are of course positive for holding gold from an opportunity cost point of view.
The current pricing in of no US rate rises in 2016, and even the possibility of a rate cut, is more of a knee-jerk reaction to the shock Brexit vote and its implications. The Fed will wish to keep its powder dry in case of a genuine economic crisis in the vein of 2008. If other major central banks cut rates and the Fed leaves its benchmark rate unchanged for the remainder of the year, this will still leave the Fed looking like one of the more hawkish central banks. Further rate cuts by the BoJ and ECB are increasingly likely however, and these would probably be the catalyst for a weakening of the yen and euro, and therefore a relative appreciation in gold priced in those currencies. While gold would probably benefit to an extent as a safe haven/risk diversifier, some of this would be offset by relative gains in the US dollar, which would act as a headwind on dollar gold prices. Much of gold’s performance in the remainder of the year will hinge on whether investors continue to embrace gold on risk aversion, or sentiment becomes more ‘risk on’ and investors liquidate gold positions.
Longer term, the policies being pursued right now by major developed economies have the explicit aim of raising inflation to break out of a disinflationary spiral. This is not only desirable because it implies higher economic growth, it also means that some of the massive amount of sovereign debt that has been accrued since 2008 ($3.5 trillion of public debt in the US alone) will be inflated away: higher inflation is both necessary and desirable – when it comes, and timing will be crucial, it will give gold a chance to shine as an inflation hedge.
Dr Jonathan Butler is Precious Metals Strategist at Mitsubishi Corporation in London where he is responsible for business development as well as Mitsubishi’s global research on the gold, silver and PGM markets. Jonathan previously worked as Publications Manager at Johnson Matthey, where he led the publications team and was responsible for producing the company’s semi-annual benchmark ‘Platinum’ reviews. Jonathan gained his doctorate in geosciences from the University of Edinburgh and also holds MSc and MA degrees from the University of Oxford.