Gold shines even brighter in times of monetary stimulus


Since virtually all of the world’s primary monetary policymakers are engaged in similar action, currencies should depreciate against the only credible alternative – gold

IT IS more than one month since Mario Draghi, the European Central Bank president, revealed the monetary policymaker’s latest “shock-and-awe” response to the seemingly interminable euro zone debt crisis. Frankfurt’s latest manoeuvre was quickly followed by news from Beijing that the National Development and Reform Commission had approved 60 new projects, centred on roads and infrastructure projects, totalling more than $150 billion.

The flood of stimulus measures, designed to boost flagging global economic growth, did not end there. One week later, Ben Bernanke, chairman of the Federal Reserve Board, declared that he would do whatever proved necessary to jump-start the US economy. His words were accompanied by the third round of quantitative easing, which, unlike previous programmes, is limited neither in duration nor magnitude.

Not to be left out, the Bank of Japan joined the stimulus offensive within a matter of days, announcing an unconventional monetary programme of its own. Although the latest central bank action is capped at a relatively paltry $126 billion, the monetary policymaker hinted that it would engage in further monetary stimulus, and consider other unconventional policy initiatives, if the latest measures did not fulfil objectives.

Investors greeted the bold central bank efforts to thwart an even deeper global slowdown than is already plain to see with all-too-predictable enthusiasm. But the initial euphoria has faded, as market participants come to terms with the fact that monetary policy is relatively impotent in the face of strong structural headwinds that include the demise of the debt-driven economic model across the Western world, alongside a much-needed rethink of the investment-driven model that has underpinned economic growth in China.

As stock prices struggle to add to their impressive summer gains, gold has awoken from a slumber of several months. Its recent upward move has brought year-to-date gains close to 17 per cent, and the price of the precious metal is now within 6 per cent of the record high set during last autumn.

Could policymakers’ latest efforts to return the global economy to a more familiar growth trajectory signal the beginning of the latest phase in gold’s bull market, now lasting over a decade?

The latest stimulus measures, and the accompanying expansion of the monetary base, may do little but prevent growth from falling too far below potential in the respective economic jurisdictions and thus have no discernible impact on inflationary pressures. However, investors should recognise that the need for continued near-zero interest rates across most of the advanced world, not to mention round after round of unconventional monetary operations simply to keep unstable dynamics from taking hold, is uniformly positive for gold.

Gold is a monetary asset and competes directly with the world’s leading currencies, most notably the dollar, euro and yen. The precious metal is typically described as a non-income-earning asset despite the existence of an active lending market, which means that it is established convention to compare returns expected from the precious metal with those available from investing currencies in short-term monetary instruments.

Needless to say, the opportunity cost of holding gold declines as real interest rates fall and, as a result, the precious metal’s relative appeal as an investment asset rises. High real interest rates of close to 4 per cent during the 1980s and 1990s were an important factor behind the protracted bear market that struck gold bugs over the period.

Conversely, negative real interest rates through the 1970s went a long way in explaining the precious metal’s stellar performance in that decade.

Fast forward to today. Near-zero interest rates across most of the Western world, alongside an inflation target of 2 per cent in most jurisdictions, mean the monetary environment has rarely looked more favourable for gold. The structural headwinds to robust economic growth, not to mention central bank rhetoric, virtually assure negative real short-term policy rates for many years to come. As a result, it is highly unlikely that the bull market in gold is set to end in the immediate future.

Round after round of quantitative easing may not lead to a concomitant increase in the money supply due to capital-constrained banks’ unwillingness to lend and the private sector’s lack of appetite for additional debt commitments, but the expansion of the monetary base should place downward pressure on the currency of the central bank so engaged. However, since virtually all of the world’s primary monetary policymakers are engaged in similar action, currencies should depreciate against the only credible alternative – gold.

Finally, the economic crisis contributed to a rapid deterioration in fiscal positions that has seen public debt ratios jump to peacetime highs. Credit-rating downgrades have become a familiar occurrence, and the relative safety of higher-quality, sovereign credits has seen rates on short-term government bills drop to record lows in a number of countries.

However, the fiscal dynamics for most of these sovereigns is far from healthy and challenged further by an unfavourable demographic picture, which means downgrades cannot be ruled out. The relative shortage of safe, default-free assets clearly adds to gold’s appeal. Policymakers have reacted to the global economy’s latest growth slowdown with force, but the stock market reaction has been uninspiring. Meanwhile, gold’s upward march has resumed, and the precious metal is on the verge of an important break-out. Investors should take note.

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