By Chirag Mehta


There is a good chance that the global economy will enter into a recession within the next 1-2 years. Major economies of China and United States are showing signs of slowing down, and the trade war between them is accelerating this.

Lowering interest rates has historically been the first line of defense for global policy makers when staring at a recession. Lower interest rates encourage economic activity as the cost of borrowing funds falls for consumers and industries, thus pushing up spending and kick starting the economy.

Typically, rates have been lowered by approximately 3-5 per cent in response to prior recessions. But current rates are not high enough to drop, without going negative, since the time they were significantly reduced after the Global Financial Crisis of 2008-09.

For instance, with the current rate at 2.39 per cent, the Federal Reserve, the central bank of United States has much less room to cut rates.

Recession in the U.S % cut in U.S interest rates
August 1957 to April 1958 2.87
April 1960 to February 1961 2.83
December 1969 to November 1970 5.48
November 1973 to March 1975 7.7
January 1980 to July 1980 4.79
July 1981 to November 1982 10.38
July 1990 to March 1991 5.25
March 2001 to November 2001 4.75
December 2007 to June 2009 5.13

Source:
www.federalreserve.gov

Also, traditional policy options like Quantitative Easing are not generating sustainable economic growth and thus proving to be ineffective.

Enter negative interest rates.

In a desperate attempt to spur the economy and get people to spend money, central banks are making it costly for commercial banks to park their money with them. This should incentivise banks to cut rates and lend more.

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Banks are obviously expected to pass this on to consumers in the form of lower or negative rates. And when it costs people money to hold or save money, they are less likely to save and more likely to borrow and spend.

Negative interest rates have thus become part of the central bank’s toolkit for responding to an economic downturn. Something unthinkable before 2008.

Thus the amount of negative-yielding debt globally is on the rise. According to data compiled by Bloomberg as of June 2019, 40 per cent of global bonds are now yielding less than 1 per cent and $13 trillion of global debt is currently being traded at negative yields.

Countries with negative interest rates include Sweden, Denmark, Switzerland, Austria, Germany, Netherlands, Japan, and very recently even France. Belgium with a 10-year rate of 0.08 per cent and Spain with a rate of 0.39 per cent are expected to follow soon.

It amazes us as to why people world over are investing in such bonds, despite the negative yields. But it is definite that this insanity or the greater fool theory will not last long.

What could this mean for gold?

Well, interest rates are a critical factor affecting gold.

Gold does not pay interest. And thus when interest rates increase, gold prices usually soften as people sell gold to free up funds for other investment opportunities that give a higher return. As interest rates decrease, the gold prices usually rise because there is a lower opportunity cost to holding gold when compared to other investments.

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So how would negative interest rates affect gold prices?

If negative interest rates are continued to be imposed, the nominal price of gold is expected to rise over time.

This is because lower interest rates will make holding currencies like the dollar, euro, yen less attractive, diverting funds to the fall back currency –gold.

Also, funds will flow to higher return bearing assets like gold that preserve purchasing power in an environment where bank deposits and bonds will only make you poorer.

You could argue that monies could also flow into equities as a result of this low interest rate environment, but usually such rates lead to elevated market levels, making them risky – something investors are likely to stay away from. Also since gold is no one’s liability, is tangible and enjoys universal acceptance, it enjoys greater confidence than equities in such times when the world is upside down.

Clearly, negative interest rates make holding gold a viable alternative, to a bank account or bond that loses purchasing power, or to bubble-like financial markets that could wipe out your capital.

Our view? Brace yourself for more negative-yielding debt in the near future, and resulting appreciation in gold prices.

In the short-term, prices may move up or down in any investment. But if you think long term, now is a good time to allocate a portion of your funds to gold.

(Chirag Mehta, Fund Manager – Alternative Investment, Quantum Mutual Fund)





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