Gold in vogue amid high grade bond demise

Jul 21st, 2016 | By | Category: Commodities

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Gold is making a comeback this year amid falling high grade bond yields. Gold exchange-traded products have benefited from inflows of around $21bn in the first six months of the year, which is in stark contrast to last year when the asset class saw redemptions of $3.4bn, according to a report from ETP provider WisdomTree.

Investment into gold ETPs up 51% in 2012

Gold benefits from the demise in high grade bonds

The precious metal, which is now trading at around $1,319 an ounce (up 24% since the beginning of the year) enables investors to diversify their multi-asset portfolios because of its negative correlation with equities and bonds. Renewed interest in gold has also extended to the precious metals sector, which has  seen gold and silver futures rising 26% and 46% over the same time period.

According to a note from WisdomTree, the expansive quantitative easing (QE) alongside an absence of lower-bound limits to policy rates has forced markets to price-in a negative interest rate environment extending across the bond markets’ entire term structure. When real inflation adjusted yields turn negative income streams from traditional safe haven high yield bonds disappear.

One of the reasons high grade bonds are struggling is because when returns are driven solely by price, they [the bonds] become increasingly speculative assets to hold. It has consequently pushed gold to an equally safe, if not safer asset.

While gold is now trading at around $1,319  it was boosted by the EU Referendum last month when its price rallied 6.6% the day after the vote (Friday 24th June) to hit $1,337 an ounce. Despite this being some way off its highest levels seen in 2011 – when the price exceeded $1,800 – it’s a promising sign for the yellow metal, which hit its lowest level since 2009, at the end of last year.

“The “Brexit” vote short circuited market confidence anew. Risk amplified and safe haven asset prices look ever more dislocated, particularly in Europe. While dividend yields of equity markets are at a ‘post-financial crisis’ high, yields of high grade government debt have fallen to new all-time lows. To add insult to injury, sovereign bonds for indebted countries now look vulnerable amidst an exhaustive monetary stimulus playbook unable to stem the pressure of its deeply discounted banking sector, rekindling fears of systemic risks,” said WisdomTree’s report.

James Butterfill, Head of Research and Investment Strategy at ETF Securities, added that market uncertainty is likely to keep demand for gold strong for some time.

“Exposure via ETPs is a practical way to get exposure to gold. Our flagship ETP for Gold is physically backed, so if in the rare occasion physical delivery was required this could be arranged, management costs view ETPs for gold are very low relative to Gold miners ETFs for instance. We believe now the fundamentals remain supportive for gold despite the broad positive sentiment. Platinum has much more attractive fundamentals, driven largely by jewellery, autocatalyst and investment demand we see a 5th year of supply deficit being likely whilst it trades well below marginal cost. Sentiment as demonstrated by CFTC positioning is also not bullish relative to gold and therefore is an alternative, attractively valued safehaven asset,” Butterfill said.

One ETP available to investors is the ETFS Physical Gold (PHAU), which has a TER of 0.39%. For those investors who are very bullish on gold WisdomTree offers several gold and silver products, including its Boost Gold ETC (GLD), and several leveraged products such as Boost Gold 2x Leverage Daily ETP (2GOL) and the Boost Silver 2x Leverage Daily ETP (2SIL). However, investors should use these with caution.

There are also several other political and macro-economic reasons that support gold. According to WisdomTree these include:

  • QE: The appeal for gold will remain strong insofar as the macro backdrop continues to be disinflationary. Having fully unwound its QE program in early 2015 and instigated the first policy rate hike in more than a decade (to 25-50 bps in December that year), the Fed’s stance is still by any standard very loose.
  • Pro-inflation: In Japan, the economic situation is supportive of a pro-inflation biased monetary policy stance and has taught the Fed – along with Europe’s central banks – that it is easier to fight inflation than deflation. Japan’s move to lift sales tax from 5% to 8% in April 2014 (and to 10% in October 2015) sent consumer spending into reverse and destroyed the inflation momentum the BoJ’s QE programme had painstakingly worked to instil.
  • Lowly US Treasury yield: With an absence of demand-led forces spurring inflation on, a delayed rate hike cycle will mean that the yields on US Treasuries are unlikely to offer investors income that sufficiently compensates for inflation. In fact, much of the US Treasury yield curve – from maturities up to 5-years – is trading at yields below headline inflation. And, when volatile food and energy is excluded, even the 10-year US Treasuries Note is falling short, leaving investors no choice but to take on significant term or credit risk to earn any real income from US bonds.
  • Bond yield suppression: European bond yields are at negative extremes. Long term dated government bonds have recently gone into negative territory – not just in nominal terms, but also in real terms. The market now expects long term real interest rates in Germany, France, Sweden and recently the UK to follow Japan’s, hovering around a negative 0.8-1.0%.
  • ECB QE: Combined with the zero/sub-zero policy rates of Denmark, Sweden and Switzerland are making these economies vulnerable to deflationary risks. These deflationary risks cannot be underestimated: Consumer prices everywhere in Europe have struggled to grow to the 2% target followed by central banks since 2009, with most having seen either no consumer price inflation or, like Switzerland, have experienced outright deflation.  A good gauge for how long the negative interest rates environment may last in Europe is to look at how long it took the US to close its own output gap. With the ECB QE barely a year old, prolonging QE beyond 2017 is in all likelihood the default scenario to consider for the Eurozone, as is the spreading of the negative yields beyond Bunds, affecting most of the long-term structure of high-grade sovereign issues of likes of France, Austria, The Netherlands, Belgium and Finland.
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