PORTFOLIO POINT: With huge reserves of cash in their vaults, central banks are buying gold to restrain money and credit growth. The golden days are far from over.
In my note last week, A property upturn has legs, I discussed how investors should approach the prospect of another housing bubble. Steering clear isn’t the best option, as returns are likely to be very attractive and a bubble some way off. But, know thine enemy and be prepared. A few readers subsequently asked me about another apparent bubble – gold – and how it should be approached. So this week, I’ll take a look at that.
First things first, I’m not actually convinced that gold is in fact a bubble. Certainly the debate has been raging for years, and even in 2005 when gold was at what now looks like a low $500 mark concerns were growing. That’s not to say those concerns were unfounded – it was the first time since the early 1980s (although it got close a few times in the late 80s) that gold had pushed that far. Moreover, the metal had spent most of its time since the 80s trading within $300-$400. It was a clear break-out of that range.
Seven years and $1200 or so later, the debate still rages. Now my purpose today isn’t to discuss whether gold is a bubble or not. And the reason for that is, as I mentioned, I’m not actually sure myself. It comes down to what you think the intrinsic value of gold is. The fact is, I don’t think it really matters as will become clear below.
Suffice to say at this point, physical demand is rising, although perhaps not at a rate fast enough to justify a price surge of 260% since 2005. That said, demand is up a solid 50% since then (Chart 2).
The chart actually shows fairly stable global demand from 2001 to about 2007. Indeed most of the spike in demand has been since 2008 and especially over the last couple of years. Chart 3 shows exactly where that demand is coming from.
You can see from the chart that physical demand for use in jewellery has actually declined quite markedly (almost 30% since 2005). This is presumably as it has become more expensive. Gold for use in technology and ETFs has been relatively constant in contrast, while investment demand, and that from official institutions (central banks mainly) is surging. Combined, investors and official institutions have increased gold demand, relative to 2005, by 2200 tonnes (a 70% increase). Investor demand is up 280%.
Now the reason why it doesn’t matter whether gold is a bubble or not is because the factors driving this increased demand are unlikely to change over the next few years. This will be regardless of how the global economy actually travels.
If the economy improves, we get inflation. If the economy deteriorates central banks will print more currency, destroying the value of money even further – and we’ll eventually get inflation. So gold may indeed be a bubble. But under the circumstances I think it can be argued that gold’s intrinsic value has increased relative to cash. That is, gold is valued fairly given widespread currency debasement.
The reasons for gold’s inexorable rise are the same – the seemingly limitless printing being conducted by the Bank of England, the Federal Reserve, the Bank of Japan, the Swiss National Bank and, to a lesser extent, the European Central Bank. And we know it’s not going to end any time soon. The Fed has even undertaken an open-ended quantitative easing policy and is committed to ultra-loose policy for many years to come – it is just going to keep printing.
Now none of this is controversial; it’s all in the public domain. Differences in opinion (over gold and the prospects for) really come down to how much faith you have in the world’s central banks. It is whether you believe they have the tools to rein in the unprecedented amount of stimulus at the appropriate time.
Well, it’s not so much that they don’t have the tools. They do of course. The issue is whether they will – or can – use them. I don’t think central banks can use them. Indeed, I would go so far as to say that the world’s major central banks have lost control over monetary policy and this is the key reason why gold will continue to push higher.
To see this consider the Fed’s balance sheet, the assets of which are shown in chart 4 below.
The Fed has over $2.8 trillion in assets, comprising $1.6 trillion in treasury notes and bonds and something near $900 billion in mortgage-backed securities. Size matters, because what the Fed holds in assets, the financial system holds in deposit at the Fed. It’s a complicated process but at a very basic level, the more funds that are held on deposit at the Fed, or the higher the assets of the Fed, the more money commercial banks are able lend out as credit – usually at a fairly significant multiple.
It’s not that commercial banks withdraw this money from the Fed and lend it out. That’s not how it works. They use these deposits to create credit – money out of thin air. The only requirement is that commercial banks hold a small proportion of their loans as ‘cash’ at the Fed. So that $2.8 trillion the Fed has created as reserves all of a sudden represents a substantial amount of potential credit. It’s easily $15 to $40 trillion in loans, and indeed the fact is that in 2007, with $750 billion held in deposit at the Fed, home loans outstanding were $14 trillion. Just using the same multiplier now would get you home loans outstanding of $54 trillion.
Now the only thing preventing a spike in credit growth is sluggish demand from business and consumers. They don’t want to borrow money just yet, although this is changing rapidly as recent credit figures show us.
The question is, what will the Fed do as demand starts to turn? How will it control the credit creation process. Will it lift rates in order to prevent a tsunami of cash hitting the system? Well so far it hasn’t, despite a clear improvement in economic conditions. Inflation is already within the comfort zone – and yet it continues to print and hold rates near 0%.
Moreover, and by the Fed’s own admission, it won’t even consider lifting rates until 2015. Bernanke has stated publically that rates will not go up well into the recovery. The fact that the US economy is already recovering, growing at trend, gives you an indication of how reluctant the Fed will be in raising rates. Even then, rates will go up slowly, very slowly, as the Fed will not want to destabilise the recovery.
In any case, there is no point in lifting rates until it has shrunk its balance sheet. This is because increases in the official cash rate will have little impact on market rates, with all that cash sloshing around in reserves at the Fed. More to the point, it won’t be able to lift the Fed funds rate with all that cash sloshing around.
So what about draining some of that cash by selling off some of those assets (treasuries and mortgage-backed securities)? I would suggest that finding a buyer is going to be very difficult. The Fed is currently the largest player in the treasury market, accounting for around 100% of all Treasury purchases at times. That’s the reason US treasury prices are at record highs (interest rates at record lows). So, any investor who buys them from the Fed knows they will instantly take a loss – and there is no point in holding them to maturity as you get no return after inflation. So who is going to do that?
The discount the Fed would have to sell them at is going to be huge. Another method the Fed argues it can use to prevent credit expanding wildly out of control is to pay interest on those reserves. The Fed suggests banks would be reluctant to lend money out if it was earning interest on their reserves risk free. As I explained above, this isn’t how it works. Banks don’t need to actually take money out of their accounts to create credit. They don’t do this even now. They create credit as a multiple of the reserves they hold at the Fed. If the Fed wants to then pay interest on that, it’s just another revenue stream for the banks. It won’t alter how much the banks lend.
Overlaying all of this is the political dimension. Governments want lower exchange rates to rebalance growth – to lift exports. Many want lower rates to ease the interest burden on the huge public debts they carry. Austerity is being pulled back – even the IMF is urging countries to back away from austerity. Markets are scared that rising interest rates will derail the recovery, and high-profile economists around the globe rail against public spending cuts, austerity or any attempt at getting fiscal policy in order. The pressure to keep rates lower for ever is overwhelming, and the Fed will almost certainly be unable to drain these enormous reserves in a timely fashion given the spike in interest rates any attempt would bring.
You can see now why investor and central bank demand for gold has surged. The Fed, or central banks in general, simply will not be able to restrain money and credit growth in a timely fashion. Consequently, gold will only push higher as the years roll by.