How can that happen? Let’s look back first at recent central banking history and at how the central banking business has critically changed lately.
Ever since Paul Volcker got the Fed job back in 1979 and established a stellar reputation as inflation slayer, central bankers have been regarded as the most powerful policy makers, more powerful even than finance ministers, whom they can tame by a tight monetary policy any time the budget deficits threaten to trigger inflation.
The achievements are quite considerable indeed: from double digit in the Carter years, inflation is nowhere to be seen and the move has been global: even countries with a long history of money printing have come to realize that this was not an option anymore in a world where the major economies have eliminated inflation. Some have dubbed the last twenty years “the golden age of central banking” but…
Looking at the major economies, official rates are at or close to zero: Fed funds target is 0 to 0.25%; the ECB main refinancing facility rate is 1%; the Bank of England “Bank rate” is 0.50%; in Japan, the “uncollateralized overnight call rate” remains at around 0.10 percent.
Nominal rate cuts are therefore not an option anymore, depriving central bankers of their main tool.
What remains is the level of real interest rate. The name of the game for central bankers has changed as they only have part of their toolkit to achieve their objective, namely inflation expectations.
The idea is that what governs people’s choices is the real rate of interest and that from now on, as nominal rates are stuck at or close to zero, the only way central bankers can avoid deflation is by ensuring that expected inflation remains positive: if it turns negative, then cash beats anything as a risk-adjusted investment since its purchasing power is expected to increase. People hoard it and the economy stalls.
Avoiding this is the plan behind quantitative easing and central banks’ purchase of assets by the truckload: flood the market with liquidity and convince people that inflation (not deflation) is around the corner. The Fed’s balance sheet has ballooned from $800 Bn to $2.2 Trillion since mid 2007, of which 1.2 Trillion of MBS and 0.8 Trillion of Treasuries. The Bank of Japan carries about $750 Bn of government securities (JGBs and T Bills) and the Bank of England carries about £200Bn (equivalent of $300 Bn) of Gilts.
Why this insistence in convincing people that what they have been fighting against for years is still around? Essentially because central bankers might have mastered inflation, but they are scared by its opposite, deflation, as they have very little confidence in their ability to fight it, in particular because they are deprived of their major tool in a deflationary situation, namely interest rates moves as these are stuck at zero.
So what are the investment implications?
First of all, my big fat disclaimer:
The developments that follow are neither a recommendation to buy or sell any security or type of asset. Opinions expressed are based on information believed to be reliable and presented as contribution to discussions only. The only investment advice provided here is for readers to do their own research before taking any financial decision.
With this out of the way, what conclusions can we draw?
Essentially, that the business of central banking now is to ensure that interest rates stay negative as long as the economy remains in the danger zone of deflation.
Going forward, their business will be to ensure that the above-mentioned trillions remain sterilized on their balance sheets, to avoid fueling inflation.
In the interim, this bias toward negative real interest rates is a wonderful central bank put. How to profit from it? Asset classes benefiting from negative real rates in advanced economies are mainly emerging markets, real estate, commodities and gold.
Emerging markets are a profitable bet, but local policy makers can counteract pressures by cooling down the economy (see China) or imposing capital controls. Real estate is under perfusion and unlikely to wake up shortly. Commodities are a tempting game, but with this much spare capacity, higher costs are difficult to pass onward to consumers, so pricing power is uncertain.
Gold escapes from these limitations and has already handsomely profited. Can it still run? Absolutely. The recent economic past is marked by central bankers creating a new bubble any time the previous one pops. Is a bubble in gold possible? Most definitely. Would central bankers tolerate it? Absolutely. Indeed, as FDR did in the 1930’s, they will do all they can to avoid seeing their currency appreciate against gold: that would mean that all the adjustment would be weighing on the real economy, wages and prices, namely deflation.
Is this a one-way bet? Almost: returning inflation would also benefit gold.
Almost, but not quite. What is the catch? Well, if the economy picks up and central bankers hike rates to make them positive, then gold plummets. Is that likely? The odds do not favor this beyond (at most) a 25 to 30% probability at this stage. 40% would be slow growth and negative interest rates, 30 to 35% inflation and negative interest rates allowed to stay until growth is entrenched. So this gives us a 70 to 75% probability of a gold bullish scenario.
Please don’t forget to thank your friendly central banker for this.
Disclosure: Long GLD