Commentary: Gold in a world of negative interest rates

The following is an excerpt from the World Gold Council’s latest update “Gold in a world of negative interest rates.” For the full text including footnotes and charts, please visit www.gold.org.

We have entered a new and unprecedented phase in monetary policy. Central banks in Europe and Japan have now implemented Negative Interest Rate Policies (NIRP). The long term effects of these policies are unknown, but we see discouraging side effects: unstable asset price inflation, swelling balance sheets and currency wars to name a few. Amid higher market uncertainty, the price of gold is up by 16% year-to-date — in part due to NIRP. History shows that, in periods of low rates gold returns are typically more than double their long-term average.

Looking forward, government bonds are likely to have limited upside, due to their low-to-negative yields and, in our view, would be less effective than gold in mitigating risk, ensuring portfolio diversification, and helping investors achieve their long-term investment objectives. Portfolio analysis suggests that gold allocations in a low rate environment should be more than twice their long term average.

We believe that, over the long run, NIRP may result in structurally higher demand for gold from central banks and investors alike.

In the aftermath of the 2008-2009 financial crisis, central banks resorted to unconventional tools like Zero Interest Rate Policies (ZIRP) and Quantitative Easing (QE) – which had been first pioneered by Japan in the early 2000s — to (try to) stabilize prices and/or maximize employment as traditional measures had been exhausted. More recently, between mid-2014 and early 2016, central banks in Denmark, the euro area, Japan, Sweden, and Switzerland have all implemented NIRP — thus breaking the “zero lower bound”. This means that commercial banks have to pay to deposit balances with central banks.

NIRP was largely devised to counteract deflationary pressures and, in some cases, currency appreciation. However, negative nominal interest rates have short- and long-term consequences. Their effect will likely be felt by investors (big and small) and by other central banks.

Investors (including central bank reserve managers) now need to assess the risk-reward of investing in assets with negative return expectations. But the implications may be more far reaching. Such policies may fundamentally alter what it means to manage portfolio risk and could extend the time needed to meet investment objectives.

As a result, we expect that demand for gold as a portfolio asset will structurally increase. We believe there are four reasons for this, as NIRP: Reduces the opportunity cost of holding gold; limits the pool of assets some investors/managers would invest in; erodes confidence in fiat currencies due to the threat of currency wars and monetary interventions; and further increases uncertainty and market volatility as central banks run out of effective policy options to combat inflation/deflation and/or spur growth.

The link between gold and interest rates happens through investment demand. Low interest rates reduce the opportunity cost of holding gold. Negative rates magnify this. Negative sovereign debt yields in Switzerland and Japan extend out to 10 years, while those in France and Germany are negative out to 5 years. Even interest rates in the US and U.K. are extremely low across the curve, with up to 2-year debt yielding less than 1%. In real terms, the picture is even bleaker. Only yields in the U.K. are positive for maturities higher than 3 years and just a few long-term bonds yield more than 1%.

NIRP significantly reduces the likely pool of assets that investors may hold. In the current negative nominal interest-rate environment, about 30% of high quality sovereign debt (more than US$8 trillion!) is trading with a negative yield, and almost an additional 40% with yields below 1%. When yields are adjusted for inflation, the figures are even starker: 51% of sovereign debt (US$15 trillion) is trading with negative real yields and only 16% yields more than 1% in real terms.

Unless investors are willing to accept a loss-making investment strategy, they may need to consider increasing their holdings of gold. We believe this should resonate especially well with pension funds and foreign reserve managers whose investment guidelines are typically stricter and who hold a large portion of bonds in their portfolios. It is also relevant for investors with limited tolerance for risk, as well as those who have increased their stocks holdings due to the low rate environment.

Negative interest rate policies were designed and implemented to fight against deflation and currency appreciation pressures, especially vis-à-vis the US dollar. Nonetheless, currencies from all advanced countries/regions that implemented negative rates have actually appreciated against the US dollar, year-to-date, ranging from about 2% to 7%. The longer this situation persists, the greater the likelihood some central banks may pursue intervention measures. Conversely, while gold is a de-facto currency in the monetary system, it is the only one that is not targeted directly by, and doesn’t respond negatively to, expansionary monetary policies.

Investors are growing increasingly concerned about the effectiveness of NIRP. Investors are still digesting the unexpected decision by the Bank of Japan to enter the negative interest rate fray in late-January 2016, and there is a “growing perception in financial markets that central banks might be running out of effective policy options”, according to the BIS Quarterly Review released on March 6, 2016. Claudio Borio, head of the Monetary and Economic Department at the BIS, noted the following day that confidence in central banks was “faltering”.

The recent increased turbulence in financial markets serves to highlight the need for portfolio diversification and effective risk management — tasks at which gold has traditionally excelled.