Your fixed deposit: More valuable than gold?

"Why should I invest in Gold? It does not even offer me a regular source of income like bonds or deposits," asked an investor. "With deposits, I can actually calculate the returns which I will surely receive at maturity," he added.

I answered him with a question in return, "Tell me, would you invest in an instrument that actually gives you negative returns?"

"Absolutely not;" was the answer.

Quite often, while the rate of interest on investments like those mentioned above, may be a positive number, the ‘real’ rate of return earned, when looked at practically, may actually end up negative.

Real rate refers to the returns that you get after subtracting inflation. The negative returns that we spoke of earlier, comes into play when the interest rates are lower than the increase in cost of living. This means that your earnings from fixed income instruments is not able to keep pace with the increase in expenses.

In financial terms:

In times like NOW, when we are facing negative real interest rates, your (nominal) capital’s growth is constantly eroded by the loss of purchasing power.

A little detail on this front:

For e.g.: If nominal interest rates = 6% and inflation = 14%

Then, real interest rates = 6-14 = -8%

Chart: Real interest rates and Gold (India)

Source: Bloomberg
* Real interest rates have been calculated using SBI 1year deposit rates and CPI Index
** Gold prices are in Rupees per ounce and does not include any levies, duties and taxes

Understanding the link

Nominal interest rates cannot be negative, because then you as an investor would simply prefer to hold cash instead of moving to deposits / bonds. Correct? But, real interest rates can turn negative, and quite often too.

Technically, real rates are also positive. Debt investors deserve to earn a positive real rate of return, because they too have taken a (counterparty) risk with their hard-earned capital. Yes, their risk may be lower in comparison to stock investors, but then to be fair, shouldn’t they be compensated for it, no matter how little the risk involved? In the case that they are not suitably compensated, they will invest less over the long term, once they realize that they are risking their (scarce) capital for a guaranteed loss.

Would you loan money to anyone if you knew you would take a real loss for doing so? Most definitely not.

In order to promote growth, central bankers tend to force nominal rates so low that real returns plunge negative, thereby making debt investing a losing proposition.

If real interest rates turn extremely negative, investors would start moving their capital to hard assets i.e. commodities in order to maintain their purchasing power. However storing tangible goods is quite a cumbersome and expensive task, and in the case of intangible services, this is not a real possibility.

In such a scenario, investors gradually turn to gold.

Gold is a time-tested asset which keeps value over the long term. While bonds guarantee a real loss, gold will (at least) keep pace with inflation to preserve the purchasing power of your capital. Hence, when central banks attack debt instruments, investors gradually forsake losing bonds and eventually migrate towards gold. The longer the duration for which bonds give negative real returns, the more capital gradually takes refuge in gold.

The 1970s

In the US, 1970s brought in inflationary times, when the cost of living exceeded the nominal returns available on bonds. It was seen then that debt investors, gradually shifted their capital to gold. These investors drove a strong gold bull market in an attempt to maintain their purchasing power.

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Chart: Real interest rates and Gold (US)

Source: Bloomberg

The classic bull run of the 1970s ended after policymakers were forced to dramatically hike interest rates. Only once interest rates increased to healthier levels of more than 4%, did investors shun gold and re-migrate to bonds.

And Now

In an effort to bail out speculators and the so called "too big to fail" and highly levered financial institutions, the US federal government (Fed) has embarked on an easy monetary policy. They have forced the benchmark interest rates to zero and thus lowered the cost of funds. This has led to a dip in real interest rates and has opened out realistic returns for bond investors.

However, the Fed seems to have trapped itself - lower cost of funds is necessary to repair their balance sheets and support their functioning - Any increase in borrowing costs will be a burden whose weight may threaten the so called ‘ongoing recovery’ - While an action to raise rates would prove healthy over the long term, this is apparently unacceptable politically.

As long as the Fed controls nominal rates to levels under headline inflation, real rates are going to remain negative. Investors are increasingly shifting to gold in order to manage monetary inflation and to avoid losing real purchasing power year after year by investing in bonds.

Even though gold doesn’t pay a yield, as long as it merely paces with inflation it is a much better investment than bonds that lag behind price rises.

Do Investors have an option?

Negative real interest rates prevail in an environment of low growth expectations and high uncertainty. Low growth expectations would discourage spending and induce households to save, thereby driving interest rates lower. On the other hand, risk premiums usually increase in light of high uncertainty in the economy. This leads to heightened risk aversion leading investors to seek more safe assets, which in turn drives down the return on safe assets.

Both forces seem to be working now and are likely to persist going forward too.

Investors have two choices to opt for:

1. Hold cash in form of deposits which guarantees a loss of real value; or
2. Invest in gold which preserves your purchasing power and maintains the value of your money

Moving into gold seems to be the rational and practical approach and as realisation dawns, this shift of money into gold will only drive gold prices to much higher levels.