by David Roche
Central bankers’ rhetoric often conveys a sense of omnipotence. But the evolution of the post-crisis global economy clearly tells a different story.
Unconventional policy tools are increasingly prevalent, but growth rates everywhere continue to weaken and the debt overhang that triggered the crisis has worsened. Private-sector deleveraging in developed markets has been replaced by higher fiscal burdens, while debt levels in emerging markets have now converged with their more highly indebted and wealthier peers, principally because of exploding corporate leverage.
Meanwhile, hitting central banks’ inflation targets remains a distant hope. This is not a backdrop against which dreams are made.
There is a good probability (20% to 25%) that the US could enter recession this year. Over two years, that probability rises to 45%. If it were to happen, and the world followed suit, central banks would have to take their deposit rates deep into negative territory and print more money. They have no other tools left.
Negative interest rates will inevitably be transmitted to individual and institutional holders of cash. Otherwise central banks will be unsuccessful in forcing excessive savings into consumption. That will be central banks’ only efficacious tool to sustain economies if another global recession hits. Forcing banks to lend for corporate investment purposes will be a failed policy. It already is.
Cash holdings will initially be plentiful. Consumers, expecting lower prices will hoard cash, as will investors, fleeing negative returns on many risk assets. Of course, investors will buy government bonds with positive yields, but the holders of cash will be penalised. Either they will hold bank notes or they will buy gold and stuff both of them in mattresses, chimneys and safe-boxes.
Negative interest rates create a favourable environment for positive returns for gold. It wipes out the opportunity cost of holding an asset with 0% yield and which is, after all, a store of value. The alternative is paper money or a negative-yielding deposit and of course the fast-shrinking stock of positive-yielding sovereign bonds.
Gold selling has begun to reverse, although the rebound is very modest so far. Holdings are still down 40% from their peak (or 60% in dollar terms). Central bank buying has added about 746 tons of gold to holdings over the past year. Official purchases are likely to accelerate as the world’s currency management unravels into an unpredictable race to the bottom in terms of fiat currency debasement. The central banks are both practitioners and victims of debasement. They should be well aware of the consequences of their policies when it comes to protecting the value of their international reserves.
The motivation for EM residents to increase their gold holdings is strong and getting even stronger. For Chinese mainland dwellers, entering the Year of the Monkey, you would have to be one of the three wise monkeys (who hear, see and speak no evil) not to want to get out of low-return renminbi alternatives into a US dollar-denominated asset. Given capital controls, limits on holdings for foreign currency deposits and the doubtful solvency of the domestic US dollar corporate bond markets, what else do you buy? Frankly, given the rarefied quality of economic mismanagement of EMs like Brazil, South Africa and Russia – let alone the oil-price stricken Middle East – why would their citizens not dodge the on-coming train of negative returns by holding more gold?
You will notice that there is not one mention by me of gold as an inflation hedge. This is because it is unlikely we will see any. If this is wrong and inflation were rekindled, that is more likely to boost the gold price than subtract from it. That’s for a simple reason: yields on other assets would be negative in real terms, and they would struggle to catch up. In doing so, they would massacre both bond and equity prices – and restore gold as an inflation hedge.