Feb 10, 2015

Gold, Silver and Interest Rates

By   Darren V Long   |   Tags:Bullion, Darren V Long, Gold, Gold Coins, Hard Assets, Precious Metals, Silver, Silver Coins   |   Category: Blog

Apprehensions are growing that US dollar interest rates are due to rise in the coming months, which will bring about essential changes to the valuations of all asset classes, including gold and silver. However, gold and silver should weather rising interest rates best.

Higher interest rates will affect all conventional asset classes for palpable reasons, but their effect on precious metals is not so clear cut. There are two ways in which rising interest rates affect any asset class, including gold and silver: these are the higher risk-adjusted returns available on investment alternatives, and the financing cost of holding an investment position.

Physical gold and silver, except leasing and backwardation opportunities, offer no yield, so an increase in interest rates reduces their comparative attraction to other asset classes. While this may dissuade investors from increasing their exposure to this asset class, their very limited exposure of less than three per cent, means they have little to actually sell. Public, as opposed to portfolio exposure is mostly through Exchange Traded Funds (ETF’s), which can sensibly be classified as hoarding or stacking as many have heard us say on The Real Money Show, rather than investment; so many, if not most of ETF shareholdings are not subject to portfolio management considerations. Furthermore there is a tendency for investors to regard precious metals as an insurance policy, so higher returns on other asset classes is not in itself a reason to sell.

Greater selling pressure will be exerted on geared portfolios (leveraged) , and in this respect, ownership of physical metal is limited. The hedge fund industry does have some physical gold exposure, but this is generally ungeared and restricted to a small number of specialist funds. Almost all the geared activity by hedge funds and other speculators is in the paper markets, particularly futures and options. But margin requirements mean that both longs and shorts are equally affected by a rise in borrowing costs, so higher interest rates are basically an incentive to reduce positions overall in the sense of the broader marketplace, meaning a good portion of these unused funds may find their way into physical gold and silver bullion.

However, the incentive is not even. The cost of finance for futures margins is both lower and its availability is greater for the large banks, which are almost all short. They can therefore be expected to use higher interest rates as an opportunity to increase their positions and force prices lower.

The abovementioned gives us an ephemeral technical summary of the gold and to a lesser extent silver markets in the event of rising interest rates. We can conclude that selling pressure on the physical will be generally limited, and selling is more likely to be seen in the futures markets. To assess the overall importance of these factors we must broaden the debate to consider the impact of the wider financial and economic background. Of far greater relevance is the impact of rising rates on the US dollar, and this is what should be considered, especially as it relates to gold and silver.

On the face of it, rising interest rates will attract investment flows into the currency, making it rise. Dollar bulls might also argue that significantly higher rates leading to asset liquidation would also be good for the dollar, since dollar cash represents the risk-free position for most international portfolios; and we have seen this develop on no less than four occasions throughout this metals bull market and during my tenure at Guildhall. There is some logic in this, but there is one example of this which we can draw upon for comparison and that is the UK’s experience in the 1970s, which strongly suggests this might not be the case.

The various UK governments of the time tended to run uncomfortably high budget deficits, funded by sales of gilts and an expansion of money supply (Very similar to many countries nowadays). When there was inadequate demand for gilts at the prevailing yields the Bank of England was faced with a choice: raise interest rates, or print money. Under political pressure not to raise rates they always chose the latter as a temporary measure, in the hope they could buy enough time to lean on the pension funds and insurance companies to buy more gilts with their accumulating cash; very similar to today’s US currency flows but instead in today’s global picture there is a far larger base of currency and many more countries involved.

Unfortunately, not selling gilts and printing money sharpened inflation worries among fund managers, and importantly, foreign holders of sterling. This was the basis of a self-feeding cycle of currency weakness leading to higher raw material costs, rising stagflation fuelled by printed money, and to falling real interest rates due to increasing inflation. So yet higher gilt yields were required for successful funding; and you can see the same cycle in today’s marketplace happening constantly.

The BoE was always behind this curve, raising interest rates insufficiently to break the funding log-jam. Eventually, they would be forced to raise interest rates abruptly and significantly to regain control of the gilt market. Gilts would then be sold in greater than needed quantities, sterling would recover strongly and interest rates would fall.

A repeat of this painful experience is now faced by the US today. Companies from all over the world lead by some of the biggest such as PIMCO are giving advanced warning of a buyers’ strike, whereby Treasury auctions will fail to attract real buyers. Their failure may well continue to be covered up for a time through now and even beyond to QE-who knows, or by central banks buying each others’ issues and other such actions; but now that stagflation has become a real hazard, we must consider the possibility that attempts to overprice Treasuries by these means will backfire badly on the currency.

We must consider the consequences of the Fed always being too slow to raise interest rates, just as the BoE was in the 1970s. We must also consider the consequences of money being daunted by a rising interest rate trend and its effect on bond and asset prices, rather than attracted by better nominal returns. The political and economic pressures not to raise interest rates adequately are greater on the Fed today than they were on the BoE in the 1970s. Furthermore, America has the added burden of being deeply ensnared in a debt trap, where higher interest rates increase the future borrowing requirement excessively.

The betting man has to side with the bet that suggests the Fed will try to keep real interest rates negative by any means. To fail to do so would bring forward a national debt crisis that would most probably break the banks, whose loan collateral would then be collapsing in value. With or without a banking crisis, government revenue would collapse and its expenditures heighten. So long as this is the case, further inflation or stagflation is the most likely outcome, which is generally beneficial for precious metal prices in dollar terms.  If you look at the 1970’s it took gold over 2300% higher well its little brother silver improved some 3200% in the same time span.

America is not alone with this developing problem: the UK, despite their attempt to rein in public spending, faces the problem as well, and the EU is a smorgasbord of ever-increasing funding requirements. For this reason, the hedge against a falling dollar cannot be to find refuge in these currencies. If anything, the US, UK and EU make the problem far worse for each other by having to compete for genuine funds. The only other large and liquid alternative, the Japanese yen, is not now seen as a lower-risk alternative and other currencies are too small to absorb the large money flows seeking protection from the collapsing purchasing power of the dollar, euro and pound.

It is against this background that gold and silver will be valued and valued highly. The bullion markets are simply too small to absorb the trillions seeking to dodge the deteriorating fundamentals behind the major currencies. This does not mean they will be overlooked: rather, the potential for them to rise is greatly enhanced. Precious metals markets will not be too small for portfolios, whose exposure as a whole is estimated to be less than three percent globally. They can readily increase their exposure at the expense of other asset allocations. Nor will the demand of the Chinese, Indian, Russian, or other central banking systems around the world diminish for gold and perhaps even silver very soon, instead it will accelerate.

The question remains, to what extent will the banks running short positions in precious metals on the futures markets manage to manipulate prices downwards, on the basis that rising interest rates should lead to lower prices? There is little doubt they will try it, but so long as real interest rates adjusted for both actual and prospective inflation remain negative, the strategy seems certain to backfire.

We can therefore conclude that rising dollar interest rates will be the result of a drop in the currency’s purchasing power, and not a tool used by the Fed to support the dollar by taking advance action. So long as this remains the case the bull market in precious metals will continue its powerful course to new highs.  Do you own gold and silver?

Yours to the penny

Darren V Long


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