Our weekly commentaries provide Euro Pacific Capital’s latest thinking on developments in the global marketplace. Opinions expressed are those of the writer, and may or may not reflect those held by Euro Pacific Capital, or its CEO, Peter Schiff.


John Browne

Monday, April 18, 2016

As 2015 came to a close, most investors believed that 2016 would be a year dominated by a series of Fed rate hikes. That conviction solidified in mid-October when comments from multiple Fed officials convinced many that prior hints that the Fed would stay at zero percent rates had been false alarms. The Fed delivered on its promise in mid-December by actually raising rates by 25 basis points. Based on this, gold declined by 10% from October 14 to the end of the year, nearly matching its six year low. Many on Wall Street thought the declines would continue into 2016. They were decidedly wrong.
In the first 14 weeks of the New Year, gold rose 16%. The first quarter qualified as its best beginning year performance in 30 years (CNBC, E. Rosenbaum, 4/14/16). The reversal was prompted by stumbling stock markets and a series of sharply dovish turns from central banks around the world.
Perhaps the main reason people buy gold is as a hedge against inflation. But uncertainty and fear contributed undoubtedly to gold’s stellar first quarter rise. But will it continue? Opinions vary among some of the most revered gold analysts in large financial firms. They remain focused almost exclusively upon the major historical influence of the inflation outlook and possible rate hikes. And as a result, the mainstream financial firms have yet to alter their decidedly bearish outlook on gold. This could prove positive for those who take the contrarian position.
In March, Kitco reported that Robin Bhar, head of metals research for Societe General, forecast an average gold price of $1,150 an ounce for 2016. Combined with the likelihood that fear and uncertainty are receding, Bhar believes that there may be a growing realization that “the risk of an imminent U.S. recession, while not negligible, is far lower than the markets are currently factoring in.” He expects the Fed could deliver multiple rate hikes in 2016 and perhaps several during the course of 2017. If this were to happen, the dollar should strengthen and gold should fall.
Mr. Bhar’s view is supported by Goldman Sachs’ global head of commodities, Jeff Currie, who in a CNBC TV interview on April 5threcommended not just a sell of gold, but a short sale. Given the drift of central bank policies around the world, it’s hard to imagine why these banks can hold to these beliefs. This is particularly true in light of how widely and rapidly negative interest rates are spreading around the world. Bloomberg reports that as of Feb. 9, 2016, over $7 trillion of bonds, comprising some 29 percent of the Bloomberg Global Developed Sovereign Bond Index, offered negative yields. Another $9 trillion yielded zero to one percent. It is widely accepted that this number will grow rapidly as central banks push yields deeper into negative territory. These rates have already started to be passed through to consumers, who are being charged interest on their bank deposits.
Negative rates are now looming so large that on April 15, the Wall Street Journal dedicated almost its entire “Money & Investing” section to the global consequences of negative rates, a phenomenon that has no precedent in human financial history.  The section included five separate articles that detailed the absurdities of negative rates, the strains they are placing on the financial system now, and the risks they create for the future.
When bank charges are leveled on cash deposits that earn no interest, which are held in debased fiat currency, it may become tempting for more and more individuals to withdraw their funds. Their alternatives could be to buy stock investments, or to hold physical cash in the form of bank notes (which may or may not be stuffed into mattresses). A fall in bank deposits could hurt banks just when they may be hit with fines and increased regulation. Furthermore, even if arguably remote, falling deposits could trigger a cycle of further withdrawals. Given that central banks may confront such a scenario with even more currency debasement, precious metals could become an alternative form of cost-free cash.
Sovereign debt (including negative rate bonds) form ‘safe’ holdings in the portfolios of major banks, insurance companies and pension funds. In fact, one of the stories in the Journal described how German insurance companies are required to hold large quantities of “safe” government debt as “assets.” But these instruments not only offer negative returns, but they are vulnerable to declines in value if interest rates for newly issued bonds were to rise to anything approaching ‘normal’ rates. It may be unlikely that these bonds will allow the insurance companies to meet the promises they have made to policyholders. A similar dynamic could threaten the financial viability of the world’s “too big to fail” banks. This is just one more reason that we feel the world cannot tolerate a return to free market interest rates at this time.
If the U.S. economy were to further approach recession, the Fed might have to choose between restarting its Quantitative Easing program or following Europe and Japan into negative territory. A return to QE would be problematic on two levels. Firstly, QE has recently been tried by the Fed, and there is little consensus that it was effective. Also, the goal of QE is to lower long term interest rates. But as long term rates are already at record lows in the United States, it is questionable that the Fed can push them down much further. This leaves negative rates, which work on the short end of the yield curve, as the more likely option. Notably, when asked in February at a Congressional hearing if the Fed would consider moving to negative rates, Chairwoman Janet Yellen refused to take such an experiment “off the table.”
If negative rates fail to generate growth, and there is no sign that they will, central banks then may take the next logical step down the endless stimulus path. They may decide to bypass the financial system as a pathway to issue newly created fiat money (as in Quantitative Easing), in favor of delivering money directly to consumers. This is what is known as “helicopter money,” which the banks could drop from the skies onto an economy in hopes of getting consumers to spend. (But with consumer demand as low as it is, it remains to be seen whether consumers will spend such a windfall or hoard it.) While these policies are still on the fringes of central bank discussions, they may not be so for long.
It should be apparent that bankers will not be deterred from trying any policy imaginable that punishes savers and destroys the value of fiat currencies. As these policies have shown to fail to achieve their goals, we should imagine that they will be administered for many years to come.
Having risen so fast this year, and with confusion apparent even at the Fed regarding the outlook for interest rates, the price of gold could correct in the short-term. However, over the medium to long-term we remain very bullish. This view will be validated or impeached based on the behavior of the Federal Reserve over the next few months.
This is not a solicitation of any order to buy or sell.

Source: John Brownes Market Commentary