Investment Strategies

GUEST ARTICLE: Economic Angst Puts Gold Back Into Play

Adrian Ash BullionVault Head of Research 4 April 2016

GUEST ARTICLE: Economic Angst Puts Gold Back Into Play

Derided in some quarters as out of date as a store of value, gold continues to attract followers and recent economic worries have pushed up its price. This article sets out the reasons for its continued attraction.

The following article on the state of the gold market and the investment case for gold is by Adrian Ash, who heads the research team at BullionVault, a firm enabling investors to trade in the yellow metal. Gold continues to have its followers who see it as a portfolio insurance tool. Pictet, the Swiss private bank, for example, says it is looking at the option of increasing its stake in the metal. Nevertheless, gold is still sometimes disregarded by conventional finance as a "barbarous relic", to use Keynes' notorious term. The editors of this publication are pleased to share these views with readers; they do not necessarily endorse all the views of guest contributors.

Gold tends to do well when other assets fail to perform, but it does best when people lose faith in central banks. Hence the 20 per cent surge so far in 2016, gold's strongest start to a year since 1980.

Stock-market jitters have helped. Neither the S&P500 nor FTSE-100 managed to regain 31 December's closing level on any of the first 50 trading days of the New Year – something last seen ahead of Lehmans' bankruptcy of 2008 and the dotcom crash of 2000 before that.

But the real scare of 2016 to date has been the threat of deflation spooking central banks worldwide. Their desperation to stop real interest rates rising as living costs fall has suddenly put gold back on the agenda for real money mandates.

Gold pays no interest of course, but it cannot be destroyed. That makes it very different from bank deposits or debt instruments. Gold's plainest opportunity cost, therefore, is the interest or yield you could be earning elsewhere, plus the cost of insuring and storing it securely. This makes gold prices highly sensitive to changes in interest rates, specifically the real rate of interest, accounting for inflation, and most especially the direction of travel, rather than the absolute level.

A chart from the St Louis Fed (see this link)  shows the one-year percentage change in real gold prices, adjusted for the US Consumer Price Index, versus the percentage-point change in real US 10-year Treasury yields. Across the last 45 years it shows:

- Real yields and real gold prices moved in opposite directions in 60 per cent of all months;
- When real gold traded 10 per cent higher or more from 12 months before, real yields had risen only 35 per cent of the time;
- When real gold lost 10 per cent or worse, real yields had risen 74 per cent of the time.

That said, anyone claiming to have found a consistent, reliable and tradable relationship between gold and any other asset simply hasn't been watching or playing for long enough. Gold's famous non-correlation with equities, for instance, in fact comes about because sometimes it shows a near-perfect positive connection, and sometimes a near-perfect negative relationship. Across time, those readings average out to zero. But tick-by-tick, gold may show a correlation with stocks near +1.0, moving almost in lockstep, or of -1.0 as it moves in entirely the other direction.

Gold's underlying relationship with interest rates, however, has come into sharp focus after the metal hit new six-year lows last December, when the US Federal Reserve finally pulled the trigger after 12 months of shilly-shallying and raised its key policy rate to a ceiling of 0.50 per cent. Since then, all but 13 of 78 central-bank meetings worldwide have voted to hold or cut rates, with the European Central Bank cutting its refinancing rate – the key interest rate in the world's single largest currency zone by GDP – to the 0.00 per cent level barely vacated by Janet Yellen's team. The fourth largest economy, Japan, has meantime followed the European Central Bank, Switzerland and Sweden into what many people find the frankly insane policy of paying negative deposit rates, charging commercial banks for holding excess reserves.

A negative interest rate policy's power to boost new bank lending - its intended aim - remains unclear. Excess reserves at Eurosystem banks have in fact swollen, not been deflected into new business loans, since Frankfurt adopted the policy in 2014, reaching a new monthly record this January of almost 500 billion and now costing commercial banks €1.8 billion pro rata. ECB president Mario Draghi then made such a mess of his March press conference that the euro jumped on the FX markets despite his team slashing deposit rates to minus 0.4 per cent and growing new QE money creation by one third to €80 billion per month. Haruhiko Kuroda at the Bank of Japan is also now struggling even to devalue his currency. But they have made it more expensive to hold cash at the central bank than to store and insure large-bar gold in secure vaults.

Japan's negative deposit rate is now approaching commercial storage charges on physical bullion. Swiss Libor and the Swedish Riksbank's deposit rate already exceed even the higher fees of gold-backed exchange-traded funds. The cheapest major gold ETF, the iShares Gold Trust, charges 0.25 per cent per annum. It has seen such a surge in demand for shares so far in 2016, it failed to keep up with the necessary paperwork for the US Securities and Exchange Commission, suspending new creations for two days in early March. 

Charging 0.40 per year, the biggest gold ETF, the iShares SPDR, has also seen demand jump from end-2015's eight-year low, expanding the quantity of bullion needed to back its shares by almost 25 per cent, the fastest pace since the Greek debt crisis broke in summer 2010.

Commercial storage charges for large-bar gold itself, rather than securitised exposure through trust-fund structures, run nearer 0.10 per cent in London's wholesale market. Customers of BullionVault pay 0.12 per cent per year with a choice of London, New York, Singapore, Toronto or Zurich. Again, demand has jumped in 2016 so far, with the number of new account openings doubling in February from the previous 12-month average. Die-hard gold investors never trust the fiat money system, of course. But central bankers seem hell-bent on making gold bugs of us all as their "unconventional" policies grow ever more desperate.

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