Rising interest rates and precious metals
Concerns are growing that dollar interest rates are due
to rise in the coming months, which will obviously bring
about fundamental changes to the valuations of all asset
classes, including precious metals. However, precious
metals should weather rising interest rates best. At the
other end of the risk spectrum lies government bonds,
and the most powerful endorsement of these concerns is
the elimination of all US Treasuries from the PIMCO
Total Return Fund. This fund is the largest bond fund in
the world and is dollar-based, so this is a very, very
important signal for both the Fed and other bond
investors.
We
do not know to what extent PIMCO’s investment committee
shares the concerns expressed in my article of last week
about
governments losing control of the markets, but they
obviously expect a significant rise in yields all along
the curve. Higher yields will affect all conventional
asset classes for obvious reasons, but the 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 relative
attraction to other asset classes. While this may deter
investors from increasing their exposure to this asset
class, their very limited exposure of less than one per
cent, means they have little to actually sell. Public,
as opposed to portfolio exposure is mostly through ETFs,
which can sensibly be classified as hoarding, 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, 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.
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
foregoing gives us a brief technical summary of the
precious metal 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 dollar, and this is what
we must next consider.
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.
There is some logic in this, but the UK’s experience in
the 1970s 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. When there was
insufficient 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, and being of Keynesian persuasion,
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.
Unfortunately, not selling gilts and printing money
heightened inflation fears among fund managers, and
crucially, 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.
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 suddenly
and substantially 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 uncomfortable experience is now faced by
the US today. PIMCO’s investment strategy is an advance
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 QE2 to QEn,
or by central banks buying each others’ issues and other
such actions; but now that stagflation has become a real
threat, 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 deterred 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
sufficiently 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 disproportionately.
The
betting has to be that the Fed will try to keep real
interest rates negative by any means. To fail to do
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 expenditure escalate. 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.
America is not alone with this developing problem: the
UK, despite her attempts to rein in public spending,
faces the problem as well, and the EU is a smorgasbord
of escalating 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 precious metals will be
valued. The markets for them 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 only 0.6%. They
can readily increase their exposure through ETFs and
mining shares at the expense of other asset allocations.
Nor will the desire of Chinese and Indian hoarders
diminish, 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.
11 March 2011
