By Ben Kramer-Miller

We’ve been arguing that rising interest rates should correlate to a rising gold price.  When interest rates are broadly rising this signifies that demand for future money is falling, and this in turn indicates that the population is expecting inflation.  This expectation is reflected in high commodity prices broadly, but since near-term production impacts the supply of every commodity except for gold, these other factors make the correlation with interest rates only partial.

Commodities are valuable for their intrinsic value, and demand is determined by their use-value.  While commodities other than gold may be stockpiled for their exchange values there are generally particular circumstances leading up to this (e.g. cigarettes being used as currency in prisons, or metal scraps being hoarded during times of hyperinflation).  Gold, on the other hand, does have use-value in industrial applications, but the bulk of its use-value is in its exchange value (there’s no reason why we should assume that the two are mutually exclusive).  Since gold is intrinsically valuable for its exchange value, this value rises–at the very least on a relative basis–as the implicit value stocks and “loans” (e.g. bonds, bank deposits (which are simply loans to the bank)) falls with the declining demand for future cash-flows denominated in Dollars (or whichever fiat currency you like).  As interest rates fall the market places more value on future cash-flows (i.e. ascribes them a lower discount rate).

If interest rates turn negative then this shouldn’t change.  For instance if one can earn “zero-risk” 3% interest then it would be foolish to buy a stock that is fairly valued using a 1% discount rate of future cash-flow expectations.  But if the zero-risk interest rate were -1% we might justify using a 1% discount rate to value the stock.  So as interest rates decline from 3% to -1% the relative value of this security hypothetically increases.  Gold, which generates no future cash-flow, doesn’t participate because there is no future cash-flow to increase in value relative to the move in interest rates.  But as interest rates dip below 0% something else happens: any non-cash-flowing asset becomes attractive as an alternative to the zero-risk interest rate, and this includes commodities.  Commodities, of course, have what is akin to a negative interest rate insofar as they have a cost of carry, but for some–especially gold–this cost is very low.  This argument is no different than the argument for gold in a low interest rate environment, and it follows that if interest rates are negative and continue to decline that gold’s appeal will be competing with cash-flowing assets such as stocks and bonds.  Stocks should be especially attractive because their cash-flow yields can’t turn negative like those of bonds (since they have a limited duration): the cash-flow yields on stocks have a 0-asymptotic lower limit (assuming the company is profitable).  Thus money should flow towards gold, but it may not perform well relative to stocks, or even some “low-risk” long-duration bonds.

However, negative interest rates are impossible in a free-market economy, and can only be imposed upon a society by governments and central bankers.  Interest is a function of the time-value of money–money is seen as more valuable today than in the future, and somebody who wants money now pays for the right to somebody else’s money with this interest, or a payment for sacrificing control over that money for a certain period of time.  Formally, in a time period ‘t’ the value of cash-flow an asset will generate is equivalent to the expected cash-flow divided by 1 plus the discount rate represented as a percentage.  To reflect the aforementioned preference for money sooner rather than later a positive discount rate is used, and the expected cash-flow is divided by a number greater than 1, thereby making the discounted cash-flow value smaller than the expected cash-flow.  But in a negative interest rate environment the presumption is that the discount rate is negative, and the expected cash-flow is divided by a figure smaller than one, thereby making the discounted cash-flow worth more today than the expected future cash-flow itself!

Just keep in mind that the reason future cash is valued lower than present cash is that there are risks surrounding that future cash: its value might be inflated away, the issuing country may cease to exist, the borrowing party may not be able to repay, the lending party might die or otherwise be unable to use the cash when it is returned…etc.  For assuming these risks a lender is compensated, and it follows that a negative interest rate is akin to a negative price (the only other alternative is that the negative interest rate is a function of negative time, which is absurd), and it therefore makes no sense in a market economy.

So NIRP is a price-fixing scheme implemented by government in order to generate a particular outcome.  But since the market is necessarily larger than any participant, or group of participants, this scheme will fail.  Yes, various central bank statements will refer to negative interest rates, and it is quite possible that through central banker open-market purchases that some short-term government bonds will have 0 or negative interest rates, but the market reality for most assets will deviate.  Right now we are seeing at least an intermediate term rise in interest rates or a decline in the market’s demand for expected future cash-flows.  We see this in global stocks, corporate bonds, “junk” bonds, emerging market bonds, and even in some government bonds (e.g. the 2-year Treasury).

So what do negative interest rates mean for gold?  Not a whole lot fundamentally, since policymaker-mandated negative interest rates will necessarily be rejected by the market in the aggregate.  Since we’ve begun to see interest rates in the real economy tick up we conclude that the market is beginning to place less value on future cash-flows denominated in Dollars (as well as other fiat currencies).  Not surprisingly, gold has begun to perform very well.

However, negative interest rates have another impact on the gold market, and we saw this with the recent news out of Munich-Re, which has pulled money out of the European banking system (where they already have negative interest rates) and is buying gold and hoarding cash.  We’re used to being paid interest on bank deposits, which in actuality are loans to the bank.  Ironically, deposit banking began as a service offered by banks (or goldsmiths going back hundreds of years) that came with a cost.  Customers were guaranteed the safety of their savings in exchange for paying a fee.  But now deposit banking is a thing of the past.  Yes, there are “savings accounts,” and theoretically account holders are supposed to be able to retrieve their funds at a moment’s notice, but these funds have been lent out, as banks operate under the fractional reserve principle so that only a small fraction of depositors at any given time will demand their money back.

Savers don’t seem to mind, probably because rather than paying a fee they generate interest (or at least they used to), and because they probably don’t know that their banks are not equipped to handle withdrawals on a large-scale.  In a negative interest rate environment depositors are effectively lending money to their banks, but the banks confiscate funds.  This gives depositors incentive to hold cash outside the banking system as opposed to giving it to banks and paying a fee.  Dealing with large sums of cash–billions of dollars in the case of Munich Re or any large financial institution–is costly, and the physical cash simply doesn’t exist (most “cash” or “money” is nothing more than a computer entry and isn’t backed by physical cash).  Gold is available in large quantities (i.e. billions of dollars worth), it has a high value-to-mass ratio, and it is highly liquid, making it a good choice for a large financial institution looking to store assets outside of the banking system.  The impact of a NIRP-driven flight to gold is impossible to predict, but Munich Re is a large company with the assets available to buy more gold than most small countries.  If a few other firms join Munich Re–and NIRP in Europe and Japan can spawn copycats–this could have a substantial impact on gold demand.