Gold: The Good Money

Gold: The Good Money

Gold prices have rallied more than 30 per cent since the lift off in US interest rates in December. A sharp reversal in pricing, sentiment and positioning driven by myriad factors has left gold bears and bulls as polarized as ever.

The bearish camp, with analysts such as those at Goldman Sachs, tends to have a constructive view on the US dollar and the ability to raise interest rates and normalize global monetary policy, and generally a benign view on the global economy and inflationary risks.

In the bullish camp, the view tends to be more pessimistic on the global economy and the unintended consequences of monetary policy without limits. It sees the recent price action as the beginning of a multiyear bull run in gold.

There are three main factors that support the rise of Gold prices, resulting in gold being the good money in the years to come.

The first is the limits of monetary policy. In response to the Lehman crisis and to combat the threat of deflation, central banks have deployed a wide range of unconventional monetary policies. Quantitative easing and negative interest rates have been game changers, distorting the valuation of government bonds, breaking the theoretical ceiling in prices, squeezing shorts and underweight positions, and feeding what, is one of the largest financial bubbles in history.

At the epicenter of the problem are the central banks. Investors and savers around the world, faced with extraordinarily low and even negative yields in cash and fixed income, have been incentivised if not forced to lengthen the duration in their portfolios, increasing the risk of capital losses, liquidity and volatility beyond what they might intend or be able to tolerate.

Second, examine the edges of credit markets. The bubble in government bonds and duration has driven risk taking across equity and credit markets, and lending to weaker and weaker credits, often ignoring or underplaying the risk of capital losses, liquidity and volatility. It’s a bull market that feeds on itself and benefits the weakest players most, such as emerging markets or high yield.

In a world with limited investment opportunities, excessive risk taking can lead to speculation and, of course, bubbles. The damage is done but can get worse, especially if countries such as China respond to future crises with more aggressive credit expansions, as it did this year.

The current path of monetary and credit expansion is unsustainable and will eventually burst, leaving investors struggling for the return of their capital, instead of return on their capital an extremely bullish scenario for gold and other real assets.

Third, the limits of fiat currencies are being tested. Unlike in the global financial crisis of 2008, this time there won’t be any monetary bullets left. Interest rates are already at record lows, asset purchases suffer from the law of diminishing returns, and competitive currency devaluations only increase underlying problems and global imbalances.

Over the past few years we have witnessed the first stage where by bad money displaces good money, and we are at the early stages of the second and final phase, whereby good money displaces bad money.

Gold and the dollar are best placed to play the role of good money, which could result in a substantial appreciation against the bad money currencies. But the inability or unwillingness of the US to normalize its monetary policy leaves the door wide open for gold to retake its reserve currency status and put an end to the monetary super cycle that started in 1971 with the end of Bretton Woods. It is a period in which the outstanding volume of paper money has grown disproportionately to the amount of gold that once backed it.

Time will tell if central banks and governments will be able to engineer a smooth solution to the challenges ahead, or if the remedy will be worse than the disease.

Monetary policy without limits will lead to a very wild and bumpy ride and a larger crisis than the one we have been trying to resolve: which could result in a perfect come back for Gold as an asset class that would shine in times to come.

_ Farzan Ghadially