BIS March Quarterly Report And Gold

The day before yesterday, the Bank for International Settlements (BIS) released its quarterly review for March 2016. What can we learn from this publication?

Risks Of Negative Interest Rates

The Bank for International Settlements, based in Basel, Switzerland, is a central bank for central banks. It is worth following its publications because they offer many interesting insights into international banking and financial market developments. The BIS economists also used to be critical of the unconventional monetary policy, arguing that too-low interest rates and a focus on consumer price inflation may lead to asset bubbles and financial crises. In a recent review, they analyzed the experience of the four central banks in Europe that have kept their policy rates below zero for more than one year. The BIS found that modestly negative policy rates are transmitted to money market rates in very much the same way as positive rates are, and that the overnight rate has followed the policy rate below zero. However, negative interest rates are not passed to retail depositors and some mortgage rates have actually, perversely, increased. This means that negative policy rates do not feed into lending rates for households and firms, as central banks wanted. The fact that retail depositors have been shielded from negative rates so far may put the profitability of commercial banks in danger. Negative rates can also weaken the soundness of institutions with long-duration liabilities, such as insurance companies and pension funds, seriously challenging their business models. Moreover, there is great uncertainty about the behavior of individuals and institutions if rates were to decline further into negative territory or remain negative for a prolonged period.

This uncertainty has recently led to a rise in gold prices. We believe that we have not seen more financial turmoil caused by the NIRP, and more bullish reactions of gold prices, only because the markets do not believe that the NIRP is likely to stay for a prolonged period, and because retail investors have been shielded so far. However, the fact that the NIRP is not transmitted into the wide economy may lower confidence in monetary policy even further, increasing the safe-haven demand for gold.

Faith In Central Banks Fades

Indeed, the report pointed out that confidence in the central banks’ magic powers has been recently faltering. The first phase of the 2016 financial turmoil was caused by anxiety over global growth in emerging markets - China in particular. Growing concerns about the Chinese and global economic outlook, in turn, led to further losses in commodity markets. These turbulences widened credit spreads, significantly affected the high-yield bond markets. Importantly, the BIS considers sharp increases in credit spreads to be a leading indicator of recession.

Central banks reacted by offering more accommodation. In consequence, markets focused on the potentially negative effects of the NIRP on the commercial banks' profitability. Investors also became increasingly aware of the new constraints of monetary policy. As negative interest rates intensified, there was a growing perception in financial markets that central banks might be running out of effective policy options. This should not be surprising. The pace of economic growth is still disappointing. The rate of inflation remains stubbornly low. The fiscal space is tight due to excessive indebtedness, while structural policies remain very unpopular. The only potential backstops are central banks, however, with the current stance, further accommodation is limited.

Conclusions

The key takeaway is that the confidence in central banks is fading for the first time in a few years, which is fundamentally bullish for the gold market. Investors should remember that the bear market started in 2011, when the fears about negative effects of quantitative easing abated and confidence in unconventional monetary policies rose. Therefore, the increased concerns about the negative effects of the NIRP, and the reduction in faith in the power of monetary policies, should be positive for the gold market.

Disclaimer: Please note that the aim of the above analysis is to discuss the likely long-term impact of the featured phenomenon on the price of gold and this analysis does not indicate (nor does it aim to do so) whether gold is likely to move higher or lower in the short- or medium-term. In order to determine the latter, many additional factors need to be considered (i.e. sentiment, chart patterns, cycles, indicators, ratios, self-similar patterns and more) and we are taking them into account (and discussing the short- and medium-term outlook) in our trading alerts.