Financial Times begins to wonder if central banking is even crazier than gold

"Unconventional central bank policies have thoroughly distorted markets."

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Lenin's Despised Gold Becomes the Ultimate Hedge

By John Plender
Financial Times, London
Sunday, January 25, 2015

http://www.ft.com/intl/cms/s/0/6a4655a6-a0c7-11e4-8ad8-00144feab7de.html

Lenin, the implacable Russian revolutionary, despised gold. He thought it should be used to build public lavatories. I was of much the same persuasion early in my career. The yellow metal's economic utility seemed to me minimal in the light of its declining industrial uses. As an investment it was and remains entirely speculative because it yields no income. And since the introduction of index-linked government bonds, any merits it might have as an inflation hedge have become less relevant.

Certainly gold has been a very erratic store of value in recent decades. Anyone who bought gold at the peak of the gold bull market in the early 1980s saw their investment lose 80 per cent of its value in real terms over the next 20 years. And as a protection against political and economic instability it has latterly become a less reliable bolt-hole, failing to rise in price consistently in response to each new geopolitical crisis.

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The first reason was that gold, over millennia, has never defaulted. Humanity thus harbours a psychological commitment to the yellow metal that would probably take not just decades but centuries of terrible investment returns to unravel. That means it is unlikely to lose all its value in our lifetimes even if its industrial uses finally disappear in their entirely and people lose all interest in gold as jewellery.

The supply is relatively fixed and annual mine production is a minimal percentage of the outstanding stock of gold. A rise in the gold price prompts only a limited increase in annual production of the metal. There is thus no link to the economic cycle and a lack of correlation with other financial assets. The result is that gold offers very useful portfolio diversification.

The attractions become particularly compelling in periods of deflation. This is a piquant consideration at a time of global imbalances where parts of the world are suffering from deficient demand, including the eurozone. If prices are falling in depressed economies, the most obvious investment hedge is cash. Yet with currency wars, cash may be a lousy deflation hedge if central banks impose negative deposit rates to deter capital inflows.

That is one of the lessons of the Swiss National Bank's removal of the cap on the franc against the euro. In an (unsuccessful) attempt to mitigate the likely surge in the franc arising from this move, the central bank lowered the rate on sight deposit accounts to -0.75 per cent. Other countries that are perceived to be providers of ultra-safe assets will probably go down the same negative rate route in due course.

Fixed-interest bonds are likewise seen as a deflation hedge. This is undeniably true where yields are positive. Yet government bonds are showing signs of going the same way as interest on Swiss deposits.

At the short end of the market, government bond yields are negative, not just in deflation-prone Japan, but also in Germany, France, the Netherlands, Sweden, and Denmark. So to find a decent deflation hedge, investors in these countries have to take on more duration risk -- hardly appealing when economies are delicately poised between inflation and deflation. A reversion to the historic mean in bond yields would be a killer.

There lies the attraction of gold. With interest rates low or negative, the opportunity cost of holding the metal is negligible. When most other investments look expensive or simply unattractive, its lure is hard to resist. In effect, it provides a hedge against the mistakes of central bankers and monetary dysfunction. And what is the current market background if not dysfunctional?

Unconventional central bank policies have thoroughly distorted markets. Nobody can be sure that the central bankers will find a way out of this uncharted monetary maze without precipitating financial chaos. All we do know is that the recent experiment with forward guidance showed with painful clarity how little central bankers understand about the workings of the post-crisis economy.

Yet gold is a fickle mistress. Without the underpin of a yield, the price can be volatile. And for all its current attractions, it unmistakably belongs to the world of least-bad options.

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