Gold Prices and Central Bank Policy

(July 13, 2016 - by Tiago André)

Summary

Central Banks’ monetary policy is the main driver behind gold prices.

Inflation is the easier way out of the debt problem.

Negative real interest rates will continue until debt comes down to sustainable levels.

As Central Banks lose their credibility among investors, gold will continue its rally.

In this article, I’ll go deeper into Central Banks’ monetary policy because it is the main driver of gold prices.

This is what is happening right under your nose

Nations are over-indebted and facing a hard time controlling their deficits and public debt. As debt restructuring is not an option for many Sovereign States (the systemic risks are too big to ignore) and as structural reforms are too difficult to implement and take too long to provide results (certainly more than 1 political mandate), decision makers chose the easier way out of this debt problem: inflation (the hidden tax).

The main evidence of that decision is in the Central Banks’ balance sheets which have skyrocketed since 2008. In fact, any event is an excuse for them to put their paper printing machines to work. Brexit? No worries, here you go a few more billion. Euro-Area Sovereign crisis? Calm down, we’ll buy all those bonds (and increase money supply in order to do so). Bad economic data? That’s ok, just keep those printers running!

Source: Trading Economics

Second proof is the negative real interest rate policies almost everywhere in the world. Yes, savers are losing purchasing power on their savings accounts every single day and yes, debtors’ leverage ratios improve as asset prices increase. Don’t be mistaken: a transfer of wealth from savers to debtors is in place for quite some time now.

This monetary policy will continue in the years to come

Negative real interest rates will prevail until the debt comes down to levels that don’t harm economic growth.

Sure that if inflation rises substantially (and that risk is growing), Central Banks will have to increase interest rates but to levels below their inflation expectations. Even if we have deflation, Central Banks will make sure that nominal interest rates are even more negative than the annual price contraction. In fact, negative nominal interest rates are now the new norm in many places in Europe and Japan.

The consequences of this monetary policy

As interest rates go down, so does the WACC and as the discount rate decreases, asset prices increase.

In fact, this never-seen-before massive intervention is creating asset bubbles in the bond and equity markets. If Central Banks normalize their monetary policy, the repricing of all these assets will be brutal. But despite the Fed tough talk, that’s not on the cards anytime soon.

Gold and Central Banks

One of the reasons behind the last bear market in gold was the Fed’s threat of rate increases. But as time went by and the Central Bank didn’t deliver its promise, investors called the Bluff.

As it becomes once again clear that policy makers are not worried about inflation but instead welcome it and need it to come in order to solve the debt problem, gold will continue going higher. This time around I dare to say that tough talk won’t be enough to stop the rally, only a change in monetary policy.