As my colleague Jean Boivin recently wrote, central banks are pushing the outer limits of monetary policy. This has had many odd side effects, not the least of which is a significant portion of sovereign debt today is trading at a negative yield. If you buy government bonds from Japan today, you’d have to pay interest. Welcome to a world in which investors pay for the privilege of lending money.
Although central banks have been the primary architect of this surreal state of affairs, even if they decide to reverse course, real borrowing costs are likely to remain low relative to the historic norm. Factors such as demographics and tepid economic growth are contributing to the unusually low level of real interest rates (i.e. after inflation).
All told, this is a serious problem for yield starved investors. Ironically, one potential remedy is to take a second look at an asset class that provides no income: gold.
Even more than other asset classes, making predictions about gold is a dubious exercise. For starters, investors can barely agree on what gold is: commodity, currency or “barbaric relic.” Even investors like myself, who see a legitimate role for gold in a portfolio, need to admit that gold is extremely difficult to value. There is no cash flow to discount and, unlike oil or even other precious metals like silver or platinum, gold has few industrial uses.
Is now the perfect time and place for gold?
That said, some environments have been more kind to gold than others. As gold pays no interest or dividend, the opportunity cost of holding the precious metal is a critical driver of returns. During periods of low or negative real rates, when the opportunity cost is low, gold has generally performed better than in periods when real rates are higher. My colleague Heidi Richardson also mentioned this in a recent post. According to Bloomberg data, since 1971, the level of real U.S. 10-year yields has explained roughly 35% of the annual change in the price of gold. In those years in which real rates were above average (roughly 2.50%), gold rose by an average of 0.50%. However, in those years when rates were below the historical average, gold rose by an average of 21%.
While real rates have historically had the most significant impact on gold’s performance, inflation, more particularly the direction of inflation, has mattered as well. The best years for gold were those in which real rates were low and inflation was rising. Since 1971 there have been 12 years that fit that description, as Bloomberg data shows. Gold rose in 11 of those 12 years with an average return of over 35%.
Given slow growth, a cautious Federal Reserve and the proliferation of negative sovereign yields in Japan and Europe, U.S. real rates are likely to remain low for the foreseeable future. At the same time, both core inflation and wages have been firming while the inflation drag from last year’s strong dollar and collapse in oil is beginning to fade. This is exactly the type of environment that has historically been most favorable to gold.
Russ Koesterich, CFA, is Head of Asset Allocation for BlackRock’s Global Allocation Fund and is a regular contributor to The Blog.