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Interest Rate Normalization & Why Gold is Still Important

Posted On Wednesday, Apr 27, 2016

Lately, we have seen some stability and recovery in asset markets after the mayhem witnessed in the first two months of the year. Despite that gold is holding up well seen consolidating in a narrow band. Most investors lay more emphasis on recent asset performance rather than focusing on role that each investment plays when combined in a portfolio. The first two months of this year proved stressful for most of the assets in the portfolio whereas gold did exceedingly well highlighting the characteristic of gold being an excellent means of portfolio diversification. Time and again gold has proved its usefulness in times of stress in other asset markets. The bottom-line being "It is extremely important to have a small portfolio allocation to gold at all times".

At the same time it`s important to understand the pulse of each asset market and to which direction it’s headed to be able to tactically shift portfolio allocations and to benefit from it. After a spectacular run for much of this year; it’s time for gold to take a breather. Correction and consolidation after sharp moves are signs of a healthy market.

Markets have been fretting for clues on the magnitude of interest rate increases by the U.S. Fed. In a bid, they seek economic data and Fed communiqué as a way to measure future rate hikes. In line with market expectations Fed has moved back over its rate increases from four to two hikes this year. Having come to that, markets have further lowered their expectation for rate hike to may be just one hike and that too with a probability of just 62%. This is on account of Feds dovish remarks reinforcing its stance to proceed very cautiously and its overt concern of external global fragilities and its spillover effect on U.S economy.

Markets win, Fed throws in the towel. The US Federal reserve has scaled back its expectations to two from four hikes for 2016 as to what the markets were expecting post the first fed rate hike. Markets have further scaled back their expectation to may be just one hike this year with a 62% probability of just one rate hike based on Fed’s recognition of the still fragile state of the global economy. Will the Fed change its assessment further in line with market expectations? Given that it’s a presidential election year may impact Fed stance towards a rate hike.

While we believe that the Fed should continue with its interest rate normalisation and that lower rates would not resolve the current economic problems and will be unable to bring back growth. Despite years of unconventional policies of low rates even negative rates and quantitative easing, there is little evidence of global recovery – global trade is contracting and companies are in distress and laying off people. Even, in the U.S, the headline unemployment number has been falling, there has been little wage growth and the new jobs have been temporary, more un-secure and less paying. Other costs like healthcare and education have been rising faster than the wage growth. Asset price inflation is only notional and has been benefitting only the rich if at all. These negative forces have compelled masses to save more and spend less. And while consumer spending remains depressed, how is the economy going to recover?

The European Central Bank’s meeting last month reinforces the fact that central banks globally are addicted to unconventional monetary policies. Global central banks have fewer options and have become less potent and effective in their ability to reach their current goals of boosting economic activity and inflation. In a desperate attempt to lift off demand, they have pulled the rabbit from their hats in form of negative rates. With about a quarter of the world economy facing negative rates in some form and growth faltering, negative rates are becoming commonplace. Suppressing interest rates doesn`t work either, because all that happens is demand is made to shift from current to deferred consumption, introducing distortions into an economy that might look like a positive result. Also, negative interest rates convey to the public that central banks are worried about the economy and thereby make them more reluctant to spend more money. Instead, in addition to lowering returns on savings, they will make consumer sentiment worse. People may resort to hoarding cash rather than yielding negative and also to meet any contingencies arising out of the perceived economic uncertainty. This again will neither lift spending nor investments but has a potential to spark a rush to real assets like gold.

Gold has seen a good up in the last quarter. Consolidation is normal and healthy after a move like we saw. Any improvement in risk sentiment may also reduce flows to gold. However, given the global macro, downsides in gold would be limited and likely to attract significant buying on any meaningful pullbacks. Fundamentally, gold seems to be on a solid footing as central bankers have again hit the wall. Gold should benefit as central bankers attempt further measures through more newer, unconventional and untested approaches to revive growth.

Given the macroeconomic picture, gold will be a useful portfolio diversification tool and thereby helping you to reduce overall portfolio risk.

Source: Bloomberg

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