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Negative Interest Rates Give Gold (and Silver) a Competitive Advantage
For over 40 years, the rap on gold from the mainstream press and Wall Street analysts is that it doesn’t offer income. It offers no “earnings,” either, so Wall Street securities analysts don’t know how to calculate gold’s intrinsic value, even though gold is a long-term store of value and a reliable currency alternative in many historic civilizations for thousands of years. Ironically, a bride in India or a worker in China knows a lot more about how to value gold than a high-paid financial analyst in New York City.
Interest rates in Europe have been below zero for over a year, and they are likely to go even lower. Last Thursday, April 21, Mario Draghi, head of the European Central Bank (ECB), announced that the ECB is ready to use “all instruments” available, including more rate cuts and possibly more quantitative easing (an increase in available money or credit). Years ago, Mr. Draghi said he would do “whatever it takes” to save the euro-zone. His latest statement sounded like “whatever it takes” means even lower rates: to -1% or minus 2%. Where will it all end? The ECB desperately wants to ignite inflation and the easiest way to do that is to weaken the euro, making the price of imports artificially higher. The problem with that line of thinking is that it forces the other major currency trading blocs to cut their interest rates in tandem.
That’s one reason why the Bank of Japan surprisingly launched a negative interest rate policy on January 29, 2016. The problem is – with both the euro and yen – those two negative-rate currencies actually rose in terms of the dollar. So far this year, the Japanese yen is up 8.7% to the dollar and the euro is up 3.9%.
More importantly, investors in Europe, Japan and now America are buying up large amounts of gold and silver to replace their home currency, which offers no meaningful interest income for their bank deposits.
Gold Offers More “Income” than $8.5 Trillion in Sovereign Debt
Interest rates were high in the 1970s, but inflation was higher so the “real” return on consumer bank deposits was below zero. Investors preferred gold then as an “inflation hedge,” but it was primarily a hedge against currency devaluation. During the 1970s, gold rose from $35 in 1970 to $850 in early 1980 as the dollar lost 70% of its value to the Swiss franc – which offered negative interest rates at one time.
On Friday, April 15, The Wall Street Journal featured a series of three stories on Page 1 of its Money & Investing section under a six-column headline: “Negative Rates Upend the World.” The Journal broke down the national distribution of $8.5 trillion of government-issued sovereign debt that currently pays a negative interest rate. About two-thirds ($5.6 trillion) of that negative-interest rate debt was issued by Japan and the rest was issued in Europe. In addition to the ECB, the central banks in Denmark, Sweden and Switzerland offer negative interest rates. Denmark began offering negative rates as far back as 2012.
Europe’s negative rates spurred gold demand in Europe last year, driving the euro price of gold higher, even as gold was flat in U.S. dollar terms. This year, the declining interest rates in Japan have also driven gold demand higher. According to Bloomberg, writing on April 14, gold sales in Japan soared 35% in the first quarter over the same quarter in 2015. Last year, total consumer demand for gold in Japan rose even faster, 83%, since yen rates were near-zero throughout 2015. In short, if low interest rates are good for gold, sub-zero rates are better. Any time the real (after-inflation) rate is below zero, gold tends to rise.
Gold Tends to Rise When “Real” Rates Turn Negative
In the United States, interest rates are barely positive, but gold has soared this year in dollar terms since the Federal Reserve has backtracked on its December 2015 promise to raise rates four times in 2016. Now, with major economic indicators looking flat and inflation nowhere to be seen, the Fed has indicated that it might only raise rates once this year – or not at all, since 2016 is a Presidential election year.
Last month’s inflation figures (released April 12, 13 and 14) reflect a small amount of inflation on the consumer level, a small amount of deflation on the producer level and much higher deflation in imports. Import prices have declined 6.4% in the last 12 months, due largely to the decline in crude oil and other commodity prices. The March 2016 Producer Price Index (PPI) fell 0.1% and is -0.1% for the last 12 months, while the Consumer Price Index rose 0.1% in March and is up 0.9% over the last 12 months.
While U.S. consumers earn about 0.4% on their bank deposits, they are losing 0.9% to inflation, for a net -0.5% yield. As the World Gold Council reported on March 31: “History shows that, in periods of low rates, gold returns are typically more than double their long-term average.” For instance, when gold peaked at $1,900 per ounce in early September 2011, the “real” (after-inflation) fed funds rate was -3%!
Gold enjoyed its greatest modern surge in 2009 to 2011 when real rates dropped from over +2% in 2009 to negative rates below -3% (see chart, below). This is only logical, since money loses its attraction when it loses real buying power. In August and September of 2011, a 5-year Treasury bond yielded under 1% and CPI inflation was nearly 4%, giving investors a negative (-3%) after-inflation yield on 5-year bonds.
Gold closed 2015 at $1,060 since investors were convinced that the Fed would raise rates four times in 2016 (0.25% per time), bringing the fed funds rate to over 1% by the end of 2016. With inflation below 1%, that implied a small real positive return in the dollar by year’s end, so the dollar was strong and gold weak as 2016 began. However, when the Fed changed its tune, the dollar declined and gold soared.
So far in 2016, gold is up 17% and the dollar is down 4.5%, thanks to the Fed’s change of policy. As the above chart shows, gold’s most rapid rise came when the 5-year Treasury yields dropped from 1.73% at the start of 2016 to 1.11% on February 11. In those six weeks, gold rose 17%, from $1,060 to $1,240+.
Major Investment Banks Reconsider Gold
We have been making some fun lately of the many mainstream investment bankers who had nothing nice to say about gold at $1,060 but love gold now that it trades around $1,250. They are late to the show, but we welcome them aboard since it reflects wisdom to be willing to change your mind when facts change.
The latest institutional about-face in gold guidance comes from the huge French bank BNP Paribas. They began the year predicting that gold would average $960 for all of 2016. Now, they predict that gold should reach $1,400 in the next 12 months. BNP’s wealth-management team aptly reported that “Gold seems to have recovered its safe-haven status,” so that “Gold can play a portfolio-diversifying role during periods in which faith in U.S. financial assets is being challenged.” BNP’s Prashant Bhayani added that “as a hedge we think it makes sense, especially with the negative-interest-rate world we’re in right now.”
Once governments institute these negative-rate policies, it’s hard to imagine they will go back to positive interest rates unless their economies (Japan and Europe) gain some sudden strength, which is unlikely.
After all, if you were a government, wouldn’t you enjoy the prospect of paying NOTHING to those who own your debt? What if a nation’s debts actually became an income-producing asset? All of a sudden, an indebted nation’s annual budget drain for “debt service” shrinks toward zero – a tempting solution for governments burdened with untenable budget deficits and trillions of dollars in accumulated debts.
Central banks are also likely to spend more of their paper money for gold. When the world’s central banks discover that they can print currency and offer no income for their debts, they are liable to use more of their own fiat currencies to buy gold for their central bank coffers, pushing the price of gold higher.
Perhaps our own Federal Reserve will consider negative interest rates someday. In the meantime, prudent investors in all three major currency-trading blocs – the dollar, euro and yen – can now join the relatively poor middle-classes of China, India, most of Asia and Africa in preferring gold to paper money.
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