A gold bar does not pay interest. Some conclude that it must be more lucrative to hold the greenback, especially in a rising rate environment. We have a closer look at the link between gold and interest rates to gauge how investors may want to deal with the Fed’s tapering.
While some shrug off gold as a barbaric relic, most may not realize that, like gold, a hundred-dollar bill under the mattress also pays no interest. To earn interest on the hundred-dollars, you have to deposit it in a bank account. That is, you are lending $100 to the bank and expect to be compensated. Similarly, if you wanted to, you could lease your gold to potentially earn interest.
When the Federal Reserve moves interest rates up or down, gold doesn’t change. What may change at any point is how many dollars the market is willing to pay for an ounce of gold, and that is in part influenced by other opportunities available to investors, including interest bearing savings accounts. A key reason why investing in gold is a point of contention is because buying gold signals that investors would rather own something paying nothing than put that money at risk. It’s silly, of course, to discredit gold because of this, as embracing investments with varying risk profiles, including cash, has long been a lauded practice to achieve a diversified portfolio.
The Dollar’s Long Term Decline
We are not suggesting gold, or any investment for that matter, is risk free. When your daily living expenses are in U.S. dollars, your gold holdings fluctuate in value. Even if you only hold cash, your purchasing power is at risk, as the chart below shows:
Based on the consumer price index (CPI), investors holding cash have lost over 95% of their purchasing power since 1913. In 1913, the price of an ounce of gold was $18.92. As of March 31, 2014, the price of gold had risen to $1,284.01; this corresponds to an annualized rise in the price of gold of 4.3%. Clearly this rise did not happen in a straight line, but for an investment that doesn’t pay any interest, it doesn’t appear to be such a bad competitor to cash.
When Cash is King
Gold is a competitor to cash when investors don’t get properly compensated for holding cash. When real interest rates are high, as can happen when the Federal Reserve is raising rates to cool down an overheating economy, the price of gold might suffer. However, it’s not just the level of interest, but the interest net of inflation. Economists say we can measure real interest rates as the yields on Treasury Inflation Protected Securities (TIPS). TIPS are Treasury securities where payments increase with the CPI. Below is a chart supporting the view that the lower real interest rates are, the higher the price of gold:
In recent years, real interest rates according to this measure have been low and indeed negative for periods of late. This gives rise to at least two questions: even as gold has done particularly well when real rates were negative, why are there periods when gold still does comparatively well when real interest rates appear to be higher? And should real rates rise, will it exert downward pressure on the price of gold?
With regard to the question why the price of gold appears to have done just fine when real rates were low, but positive, one should wonder whether the CPI under-estimates inflation (and therefore shows a distorted picture of what real interest rates really are).
Can we Afford Rising Rates?
Can rising rates derail the gold price? If former Fed Chair Paul Volcker were in charge at the Fed today and thinking of imposing the sort of policies he imposed in the early 1980s, there would be a lot of chatter about positive real interest rates. Except that, in our assessment, we would risk a revolution if we introduced Volcker style interest rate policies today. In the early 1980s, high interest rates were painful, but in today’s environment with consumers no longer merely financing their homes, but buying just about everything on credit, higher rates may well have a crippling impact on the economy much sooner. Notably, government debt would also need to be financed at a higher rate. Currently, the U.S. government spends less than 2% on its (marketable) debt, or about $200 billion a year. Using the projections of the Congressional Budget Office, if the average cost of borrowing were to go back up to its historical average, the government would pay over $1 trillion more in interest expense in a decade from now:
We conclude it is rather unlikely that we will be facing truly positive real interest rates for an extended period, as we (consumers and government alike) simply cannot afford them. Of course the Fed is said to be independent from Congress and might prove us wrong, but given the focus of Fed Chair Janet Yellen on employment rather than inflation, we don’t see the price of gold threatened by positive real interest rates anytime soon. The recent bounce back in the price of gold appears to support our view. Said differently, while we don’t know what the price of gold will be tomorrow, we have little reason to think that the long-term track record of gold as a portfolio diversifier will be broken, even if there are quite likely going to be setbacks along the way. Our analysis suggests that the Fed will have a hard time talking tough, let alone acting tough.
Axel Merk is the President and CIO of Merk Investments, Manager of the Merk Funds. See his full bio here and follow Axel on Twitter. For important disclosure, click here.
