 Protecting Your Wealth:
Gold & Low-Interest Rates
Benjy Godley
Godley IGH
The Bullion Merchants
25 February, 2005
Japanese investors bought a staggering 233,000 ounces (71,000
kg) of gold last year. The reasons were mainly attributed to
those seeking gold, with its intrinsic value, as a form of wealth
protection, rather than for any spectacular gains. Japanese investors
are as a whole relatively conservative, so this fits an investment
pattern of diversification that you would expect. For gold is
a safe asset, a safe investment.
However, why then are Japanese investors still buying US debt,
in the same way a hoover sucks up dust? It is this sucking up
of bonds that has ensured low long-term US interest rates, much
to the puzzlement of Alan Greenspan? The same sense
of surprise has been expressed here in Britain with government
yields stuck in the 4 to 4.5 per cent range, while short-term
interest rates march upwards. What's more, it is the buying of
bonds that is stopping the ascent of gold.
So why is this happening?
There is a large suggestion that Japanese banks and insurers
are acting on "guidance" from the Ministry of Finance,
designed to assist the Government's protectionist efforts to
keep the yen as weak as possible. This is certainly all the more
plausible when you consider the Japanese economy is again teetering
on the verge of recession. I do believe this reason accounts
for a large percentage for the explanation of the actions of
Japanese investors.
I have heard other less complimentary explanations for Japanese
buyers of US bonds, with some analysts questioning their intelligence.
I have heard suggestions that Japanese investors find yields
of 4 per cent plus on foreign bonds irresistible when compared
with Japan's yields of less than 2 per cent, whilst failing to
understand the nature of currency risk. The yen strengthened
by 10 per cent against the dollar last autumn (over a period
of five weeks). That appreciation in the yen is enough to wipe
out four or five years' worth of the income differential between
Japanese and US bonds. However, I do not believe this reason
for Japanese investors (who are very smart) buying US and other
foreign bonds.
The last little statistic about the effect of yen appreciation
against the dollar adds further wait to the first explanation
of protectionist policies by the Japanese Ministry of Finance.
Certainly, sitting on a large pile of US debt must make you nervous
when you see the effects that a fall in the US dollar's value
can have.
However, there is a third often-neglected and somewhat more respectful
explanation for Japanese buying of US and other foreign bonds.
That is simply that Japanese investors have weighed up the currency
risks, and they are actually much less severe than many US &
European analysts think. Japanese investors do not need to mark
their assets to market or recognise paper losses, similar to
US & European pension and insurance funds.
This point was highlighted in the Times Newspaper. Here Anatole
Kaletsky (a UK economic analyst) highlighted this with an example,
which I shall include here:
Imagine an elderly Japanese
retiree, with cash savings of Y100 million at a time and suppose
for simplicity that the exchange-rate is $=Y100. Suppose, further,
that our Japanese saver wants only to secure the best possible
pension for his remaining 20 years of life, leaving nothing as
a legacy to his children. He can do this by buying an annuity,
backed by bond investment either in yen or in dollars. Looking
up the annuity tables we find that a yen annuity, based on today's
20-year yen bond yield, would pay 6.1 per cent annually (including
both interest and return of principal). A dollar annuity, based
on the 20-year dollar yield would pay 7.9 per cent.
Since the yen annuity pays 23 per cent less than the dollar annuity,
the Japanese dollar pensioner will be better off provided the
dollar falls by less than 23 per cent on average over the next
20 years. Thus Japanese buying dollar bonds, even at the present
overvalued levels, may not be as stupid as it seems.
This does not mean that dollar bonds are good value in the light
of US economic fundamentals. But it may mean that US long rates
remain "surprisingly" low as long as Japanese interest
rates stay near-zero -- which is extremely likely for many years
to come.
That same article also raised
another valid point about the cause of low long-term bond yields,
focusing on the regulation of pension and insurance funds in
the UK (and other Western countries). The regulatory pressure
and fears of litigation have led to these funds being driven
to "immunise" their long-term liabilities by buying
bonds regardless of price. Many businesses no longer treat their
pension funds as profit-maximising investment operations for
the future, but as balance sheet entries designed to minimise
accounting risks. The result is that companies pour their pension
payments into bonds without regard to prospective returns. The
logic is that if bond prices fall, long-term interest rates will
go up and this will reduce the capitalised cost of pension liabilities.
Consequently, there appears to be no business risk in allocating
pension funds assets to bonds, regardless of the yields they
offer. However, this also sounds eerily similar to the herd-like
behaviour of pension funds during the stampede into technology
shares in the dot.com boom. Buying Microsoft or Vodafone, regardless
of underlying value, exposed fund managers to no business risk
because the fashion for indexation ensured that competitors did
the same thing.
Life insurers are becoming similarly yield-insensitive. The restrictions
placed on life insurers (in the UK) stops the use of past performance
in selling their products. In which case, insurance becomes all
about marketing, with everyone selling the same policies based
on whatever happens to be the prevailing yield on government
bonds. They do not need to worry about implicit capital losses
suffered by customers who buy policies based on today's low yields,
due to the decline of investment competition.
Not all is as healthy as it seems in the Bond Market
A report by Barclays Capital Equity Gilt produced some interesting
findings in to the returns that investors are likely to receive
from bonds. It seems that investors today in long-term government
bonds are likely to lose money. Real rates will be severely eroded
by inflation.
Quoting Tim Bond (rather appropriate name), author of the study,
"A positive long-term real return from buying bonds near
4 per cent is very, very unlikely."
Demographic change will also play a part, negatively affecting
investment returns over the next two decades. With more baby
boomers retiring after 2006, there will be more sellers of financial
assets, reducing returns.
Other indicators are equally unpromising. More than 45 per cent
of newly issued junk bonds are rated CCC by Standard & Poor.
This represents an increase from 30 per cent in 2003, and must
be a cause of concern. The CCC status is the one above bankruptcy.
Whenever the proportion of new issuances trade at triple C rises
above 30 per cent, there must be a cause for concern.
Furthermore, it seems central banks are testing the waters of
currency diversification, evident from the Bank of Korea this
week. At first it seemed they were diversifying into dollars.
Then they backed away from their statement to suggest that they
were not going to sell dollars. In actual fact, I believe the
Asian central banks are looking to diversify their reserves,
but by increasing their trade surpluses with Europe (particularly
in light of an appreciating euro) and not from selling US dollars
or debt. In effect, substituting the US consumer for the EU consumer.
Whether it is as easy as that is a different matter. One I will
explore in another commentary. However, the mere fact that Asian
central banks could be buying less US debt than previously will
have a significant impact upon the market.
It always comes back to the Fundamentals
As an economist, it always comes back to the fundamentals for
me. The bond market continues to boom. However, the long-term
fundamentals do not look promising. Returns from US bonds are
not fantastic and do not represent good value. As this becomes
increasingly more apparent, investors will become ever more anxious,
and bonds will falter.
This could take months or years (particularly as Japanese interest
rates are so low), but Gold should then start to glitter much
higher. Similarly, it could well take one short, unpredictable
economic shock to cause havoc on the bond markets.
Conservative Japanese gold investors seem to be able to teach
us something. They understand the importance of wealth preservation
(not surprisingly from Japanese economic experiences over the
last two decades). It is coming to the stage where we should
all be heeding their advice. Despite being blinded by dot.com
style returns (a few years back), maybe we are coming to a point
when we should be looking at wealth preservation for the future.
Certainly, I consider it worth holding a percentage in gold.
Benjy Godley
Godley IGH
b.godley@godleyigh.com
www.godleyigh.com
Benjamin Godley is managing director
of Godley
IGH,
a UK bullion house providing investors with safe, secure channels
to invest in gold bullion. His background is one of the precious
metal industry, with his family's involvement in the industry
stretching back to his father and grandfather. Their refinery,
G.
C. Metals Ltd.
is still refining today as one of the few independent British
refineries. It is through this background and his interest in
Economics, in which he obtained his degree, that he has progressed
into gold trading and gold investment. He continues to write commentaries,
papers and economic studies, and it is in this personal capacity
that he writes market commentaries.
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are subject to change without notice. From time to time, the author
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2005 Godley IGH. All Rights Reserved.
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