What’s behind the growing glitter of gold Posted on March 26, 2023 by admin [ad_1] Between 9 March and 24 March, they rose by 8.2% to ₹59,545 per 10 grams. A savings account, in comparison, pays 3-4% per year and most one-year fixed deposits are paying around 7% currently. Of course, these are guaranteed returns, and there are no guarantees on gold returns. Further, the rise in gold prices has led to a slew of stories in the media asking the proverbial question—is this the right time to invest in gold? The trouble is that this is not a straightforward question that can be answered with a simple yes or no. Indeed, the question cannot be answered without going back a few years and understanding how the financial system really works, the instabilities that are built into it and the impact they have on the price of gold. During the course of this month, the world has come to know that quite a few small-and mid-sized American banks are in trouble. Along with this, Credit Suisse, a perennially troubled big Swiss bank, was rescued by its rival UBS. There is also the risk of contagion spreading to other banks. These troubles show the instability of the financial system as it exists through much of the rich-world. In such a scenario, money has moved to gold and driven up its price over the last few weeks. Over the centuries, gold has been looked upon as a safe haven, where money rushes to when things get a little difficult in the financial system. The question is how did we get to this stage this time around. Fed’s wrong bet The covid pandemic broke out in early 2020. Jobs were lost and incomes came down pretty quickly. Central banks all over the world, including the US Federal Reserve, printed money and pumped it into the financial system, to drive down interest rates to help consumers, corporates and governments. As a result, the US government could borrow at very close to zero percent, which it did. Some of this money was directly deposited into the bank accounts of people. The idea was to help people in times of trouble. Nonetheless, this created other problems. The US economy has had low inflation since the early 1980s. In fact, retail inflation between February 2012 and December 2020 had never crossed 3%. Now, the Fed had printed a lot of money and the government had put that money in the hands of people. Along with this, there were supply chain issues due to the spread of the pandemic. This created a shortage of goods and led to prices soaring in the import-dependent American economy. Retail inflation had stood at 1.3% in December 2020. By June 2022, it quickly reached a multi-decade high of 8.9%. Thanks to the American economy having not faced high-inflation for many years, the Federal Reserve termed high inflation as transitory. It was only in March 2022 that it acknowledged the seriousness of the situation and started raising interest rates. At higher interest rates, the hope is that people will consume less, decreasing consumer demand. Hence, lesser money will chase goods and services, and inflation will come down. Along with this, the hope is that, at higher interest rates, corporates will borrow less and expand less. In the process, fewer jobs will be created and that will put less pressure on wage inflation. This seems to be working, with retail inflation having come down to 6% in February. Solutions have consequences As of December 2020, the total deposits with commercial banks in the US stood at $16.1 trillion. As the Fed printed money and the government deposited some of that money into bank accounts of people, the deposits rose very quickly. By around mid-April, 2022, they were at $18.1 trillion. Banks lend money to people by giving out loans. They also invest in bonds. As of December 2020, commercial banks in the US had around $3 trillion invested in treasury bonds and agency securities. Treasury bonds are issued by the American government to finance its fiscal deficit or the difference between what it earns and what it spends. Agency securities are financial securities typically issued by a US government-sponsored enterprise. As the printed money landed up with commercial banks, their investments in treasury bonds and agency securities went up very quickly, touching a high of $4.7 trillion by February 2022, a jump of 57% since December 2020. Now interest rates and bond prices are inversely proportional. So, if interest rates go up, bond prices fall. Also, longer the tenure of a bond, the larger the fall in bond prices as interest rates go up. This is precisely what happened. As the Federal Reserve drove up interest rates in order to control inflation, prices of bonds held by the commercial banks fell. As of December 2022, the unrealized losses of these investments were at $620 billion. These losses were unrealized because bonds were on the books of banks and hadn’t been sold. Banks borrow for the short term through deposits and lend for the long term. So, as deposits mature, banks need money to pay them off. This dynamic forced some banks to sell some bonds in order to pay the depositors. One such bank was Silicon Valley Bank. It faced losses of around $1.8 billion in doing so. On 8 March, it tried to fill this gap by selling new shares worth $1.75 billion. This alarmed the investors who had invested in the bank’s stock. They sold out and the price crashed. The news spread on social media, leading to a bank run, where people started withdrawing their deposits from the bank. Soon, other banks like Signature Bank and First Republic Bank were in trouble, forcing the Federal Reserve to step in and prevent the situation from getting worse. In fact, a Reuters newsreport points out that estimates made by JPMorgan Chase & Co analysts suggest that in March, deposits close to $500 billion have been moved out of vulnerable American banks after the collapse of Silicon Valley Bank. Along with these American banks, Credit Suisse has also been in trouble. As a recent piece by Reuters pointed out: “A string of scandals over many years, top management changes, multi-billion-dollar losses and an uninspiring strategy can be blamed for the mess.” In fact, in the period of three months ended December 2022, the bank made a loss of $1.5 billion. More importantly, customers withdrew around $121 billion from the bank during the period. This has led to the risk of contagion. On Friday, the shares of Deutsche Bank were hammered down. The instability thus created has pushed up the price of gold, with the price going up by 8.1% in dollars terms between 9 March and 24 March. What about the future? In September 2008, when Lehman Brothers, the fourth largest investment bank on Wall Street went bust, the Federal Reserve started printing money in order to rescue other big banks and financial institutions. Up until this happened, the Federal Reserve would set the short-term interest rates in the economy. But, this changed a little over two years after the financial crisis broke out. As Christopher Leonard writes in The Lords of Easy Money: “Now the Fed wasn’t just trying to control short-term interest rates. It was trying to stimulate the entire U.S. economy.” It did this by printing money and flooding it into the financial system, in a bid to drive down long-term interest rates. In technical terms this was referred to as quantitative easing. It was done in the hope that as long-term interest rates fell, people would borrow and spend more, and companies would borrow and invest more, creating jobs and driving economic growth, which had been flagging. Soon this formula was followed by other central banks of the rich world. As Edward Chancellor writes in The Price of Time: “The timeline for the adoption of quantitative easing after Lehman’s demise runs from the Federal Reserve (November 2008) to the Bank of England (March 2009)…onwards to the Bank of Japan (August 2011), the European Central Bank (January 2015) and the Swedish Riksbank (February 2015).” When the covid pandemic broke out in early 2020, the rich-world central banks went back to quantitative easing. Given that Wall Street had been rescued in 2008 and its aftermath, the Main Street had to be rescued in 2020. As Satyajit Das, a former banker and author of A Banquet of Consequences – Reloaded puts it: “The global economy may now be trapped in an easy money-forever cycle.” Central banks are now used to the idea of printing money whenever the economy is in trouble. And this isn’t changing anytime soon. While central banks find it easy to launch quantitative easing, they find it very difficult to withdraw it. Also, it is worth remembering that quantitative easing or money printing has side effects. Most recently, inflation has been one. This has led to higher interest rates and huge unrealized losses on the balance sheets of small- and mid-sized American banks, leading to deposit withdrawals. In fact, from around mid-April 2022, the Federal Reserve had been gradually taking out the money that it has printed and pumped into the financial system over the years. Between then and 8 March, it had managed to suck out close to $623 billion. Between 8 March and 22 March, it has had to print $391 billion in order to lend the money to American banks which are in trouble. The larger point here is that, until easy money is around, the American and the global financial system will keep getting destabilized in ways which will be difficult to predict. As Das puts it: “Because it is expedient, easy money is seen as a solution when it is the issue.” In such a scenario, it makes immense sense to have some money always invested in gold because it is seen as a safe haven in which money rushes to in times of trouble. Of course, the right proportion depends on the risk profile of the individual investing. Gold: The India story Take a look at Figure 1 and Figure 2. Figure 1 plots the price of 10 grams of gold in rupees since January 2006. Figure 2 plots the price of one troy ounce (31.1 grams) of gold in dollars. In fact, if we look at the annual return of gold in rupees over the 17-year period plotted in Figure 1 and Figure 2, it’s around 12.3% per year. In dollars, it’s around 7.5% per year. The reason for this is that gold is bought and sold internationally in dollars. In India, it is traded in rupees. Over the years, the rupee has been losing value against the dollar and that has led to a higher return for gold in rupees than in dollars. One dollar was worth around ₹45 in early 2006. It is now worth a little over ₹82. This depreciation translates into a higher return in rupee terms. So, a depreciating rupee remains another reason to have gold in the investment portfolio. Interestingly, the annual returns of the Nifty Total Returns Index, which is a good proxy for the average returns earned on investing in stocks, also work out to 12.3% per year for the same period. Of course, if anyone had bought gold in late 2012 or early 2013, in the aftermath of the financial crisis, when it was at a very high value in dollar terms and around the time when the easy money in the global financial system was peaking, they would have made almost no return in dollars. In rupees, the returns would have been at 7.3% per year. In that sense, gold is really a play on all the easy money going around in the global financial system and shouldn’t be really looked at as just an individual investment. It should always be a part of a broader portfolio. Vivek Kaul is the author of Bad Money. Disclosure: The author has investments in gold mutual funds and a gold ETF. Catch all the Business News, Market News, Breaking News Events and Latest News Updates on Live Mint. Download The Mint News App to get Daily Market Updates. More Less [ad_2] Source link Post navigation Delhi engineer finds job after applying to 150 firms in 8 monthsTikTok ban in US? Lawmakers to move ahead with bill amid China surveillance row Leave a Reply Cancel replyYour email address will not be published. Required fields are marked *Comment * Name * Email * Website Save my name, email, and website in this browser for the next time I comment.