Mumbai: In the budget presented on 5 July, finance minister Nirmala Sithraman proposed to increase customs duty on gold and other precious metals from 10% to 12.5%. The duty will push up the price of the yellow metal in India.
But even without that, there are good reasons for the price of gold to shoot up from where it is currently due to a curious mix of global circumstances, which eerily resemble prevalent conditions in the late-2000s.
As dark clouds gather over the economic prospects of large parts of the world, the gold bulls are back. There are enough indications that the American economy is slowing down, and, hence, the Federal Reserve of the US, the American central bank, is likely to unleash another era of easy money (when interest rates are kept low to encourage borrowing). And gold is the anti-thesis to easy money… the historic hedge against rising economic risk and inflation. Hence, the price of the yellow metal has been rising.
The 2011 peak
On 15 September 2008, the day Lehman Brothers, the fourth largest investment bank on Wall Street, went bust, the price of gold closed at $775 per ounce (one ounce equals 31.1 grams).
This was the end of an era, which signified the increasing financialization of the global economy. Big financial institutions across Europe and the US had to be rescued by the government and central banks. The global economy went into a tailspin.
In this environment, the Federal Reserve decided to print and pump money into the financial system. This was soon followed by the Bank of England, the Bank of Japan, and the European Central Bank. The idea was to flood the system with money and drive down interest rates. This came to be labelled as an era of easy money.
The hope was that at lower interest rates, people would borrow and spend more and companies would borrow and expand. In the process, economic growth would come back.
Meanwhile, money printing got the gold bulls going and the yellow metal rallied big time over the next three years. Gold has always been seen as a hedge against pure paper money running wild.
While central banks were printing money in the hope of lowering interest rates, there was another angle playing out. With so much money being created out of thin air, more and more new money would chase the same set of goods and services, pushing up prices and, in the process, creating very high inflation. The only way to protect oneself against the oncoming inflation was to buy gold, or so we were told by all the gold bulls.
Of course, everyone wasn’t bullish. Nevertheless, bulls predicted that gold would cross $5,000 per ounce and even $10,000 per ounce. Gold touched an all-time high of $1,895 per ounce on 5-6 September 2011. It didn’t even cross $2,000 per ounce.
Anyone who bought gold in dollars that day in September, eight years ago, would still be sitting on losses of more than 25%. What about those who bought gold in rupees?
It makes for very different reading. The day gold peaked in dollar terms on 5 September 2011, the price of ten grams of gold was ₹28,305. Anyone who bought gold on that day would be sitting on a return of a little over 22% (around 2.6% per year on an average). While, this isn’t as bad as losing money, it is a poor transaction from an investment point of view. Fixed deposits would have yielded more.
The question is: why are returns in dollar terms and rupee terms so significantly different? The reason lies in the value of the rupee against the dollar. When gold price peaked in dollars, one dollar was worth around ₹46. Now, it’s close to ₹69, having depreciated 50% in value since then. During the same period, gold in dollar terms is down more than 25%. Given that the rupee has depreciated more against the dollar than the fall in gold price in dollar terms, the Indian investor has made money.
On 25 June 2019, gold prices hit an all-time high in rupee terms at ₹34,588 per ten grams. Between 21 May and 25 June, the price of gold in dollar terms rallied by 12.6% to $1,431.4 per ounce.
During the same period, the value of the dollar against the rupee stayed roughly the same. This has pushed gold to an all-time high level in rupee terms. Even in dollar terms, at $1,431.4 per ounce, gold price has been the highest since mid-May 2013. While gold prices maybe at its highest level in rupee terms, the reasons for gold prices rising are international.
Easy money
As mentioned earlier, the Federal Reserve and other central banks ran an easy money policy in the aftermath of the financial crisis. This included the decision to maintain the federal funds rate (the rate at which one bank lends funds to another bank on an overnight basis) between 0% and 0.25%. Over and above this, the Fed printed money and pumped it into the financial system by buying government bonds and mortgage backed securities. As it bought bonds and pumped printed money (or digitally created money) into the financial system, the balance sheet size of the Federal Reserve increased from around $905 billion in the first week of September 2008 to over $4.5 trillion towards the end of December 2014. And which is where it stayed till late 2017.
Since December 2015, the Federal Reserve has been increasing the Federal Funds Rate gradually. By December 2018, the rate had been raised to 2.25-2.5%. Further, the Federal Reserve has also been shrinking its balance sheet since late 2017. It has done so by selling the bonds it had bought. The balance sheet size of the Federal Reserve has shrunk to $3.83 trillion, as of 26 June 2019.
In the latest monetary policy meeting held on 18-19 June, the Federal Open Market Committee (FOMC), which decides on the monetary policy in the US, decided to keep the rate between 2.25% to 2.50%. Speaking to the press after the meeting, Jeremy Powell, the chairman of the Federal Reserve, said: “Overall, our policy discussion focused on the appropriate response to the uncertain environment… Many participants believe that some cut to the fed funds rate would be appropriate in the scenario they see as most likely.”
Central bank governors are not accustomed to talking in straightforward terms. The market has taken this as a hint that a rate cut is coming from the Federal Reserve. In fact, it has convinced itself.
On a broad note, the era of easy money seems well poised to return. Hence, gold prices have shot up to its highest level in more than six years.
US-China trade spat
The US and China are currently in the midst of an all-consuming trade spat. This started with the US led by President Donald Trump imposing tariffs on imports from China. In 2018, China exported goods worth $540 billion to US. The US exported goods worth $120 billion. Trump believes that this lopsided equation needs to be set right and, hence, the tariffs. China has retaliated with similar tariffs.
In the process, both the countries are losing out on the trade front. Chinese exports to the US between January to April 2018 had stood at $161 billion. This year, during the same period, they are down to around $141 billion. For the US, the exports are down from $43 billion to $34 billion. Clearly, the US is losing more in proportionate terms. This shows that the Chinese government has more control over its economy than the American government (hardly surprising) and has been able to do a much better job of implementing the tariffs. The fall in American exports has also added to idea of American economy slowing down in recent months.
But there is more to it than just this. The US dollar is at the heart of global trade. Hence, countries earn dollars through exports and use them to pay for imports. If China doesn’t earn enough dollars through exporting to the US, it won’t have enough dollars to pay for its imports. This will mean problems for the trading partners of China, in particular, countries like Brazil and Australia.
Also, over the years, a part of the dollars that China has earned by exporting to the US have found its way back to be invested in American government treasury bonds. These bonds are issued by the American government to finance its fiscal deficit, or the difference between what it earns and spends.
As of April 2019, China owned $1.1 trillion of these bonds. If China decides to sell even a small part of this, it could create havoc in the American financial system by pushing up bond yields and in the process interest rates. The US economy is a very consumption driven economy addicted to low interest rates.
While the possibility of something like this happening is very low, it is a good enough reason for some investors to seek solace in gold.
In 2018, China’s import bill stood at $1.7 trillion. Most of this trade is largely carried out in dollars. Over a period of time, if the US continues to impose tariffs on Chinese imports, China can influence its trading partners to start doing barter deals. It will be like India paying Iran in rupees to buy oil and Iran using those rupees to buy stuff from India. Along similar lines, China can pay Brazil in yuan and Brazil can then use those yuan to buy stuff from China.
Of course, this is not as simple as it sounds, but the broader point is that if Trump keeps treating China like he currently is, there is good reason for China to move its trade away from the dollar.
It’s the dollar which gives the US an exorbitant privilege. Whereas every other country in the world needs to earn these dollars, the US can simply print them. The question is: is Trump willing to put this exorbitant privilege on the line? There is great fear among investors about this. If he will go down that route, then gold prices will rally further in the longer term. In the short term, it is worth following what the Federal Reserve does in its next few monetary policies.
The bet is on the FOMC cutting the federal funds rate by 50 basis points during the remaining part of 2019. If that turns out to be the case, there is no reason that gold shouldn’t go higher from here.
Of course, investors should well remember that predicting the price of gold, like oil, is always a tricky business—given that so many factors are involved. Hence, only a portion of the investment portfolio should be dedicated to the yellow metal.
