Why is Gold Attractive?

There are a handful of reasons, but I want to highlight one – real interest rates are really, really low.  The real interest rate is what you get once inflation is taken into account.  For example, the interest rate is 4% and inflation is 1.5% the real rate is 2.5% (note: actual equation is not as straightforward, thus real rate shown is for the sake of simplicity).  So why does this matter?

One of the drawbacks of holding gold is that you are paid nothing when you purchase it.  If I hold a bond, for instance, I am paid an interest rate bi-annually for providing my capital.  On the other hand, if I hold gold, not only I am not paid for providing capital, but it costs me capital to hold it (e.g. a safe).

Today the real interest rate on a 10 year bond (10 year yield taking into account 10 year inflation expectations) is at roughly .20%, close to an all-time low.  In fact, real rates have been trending down for a long time.  During that time, gold has increased in value.  The negative correlation, while moderate, is pretty clear:

The negative correlation picks up as real yields fall for a sustained period, although interestingly is uncorrelated when real yields drop below 1.  That maybe indicates something else drives prices as the benefit from a low opportunity cost of holding gold is being reduced. 

Past performance is no guarantee of future results.

Where to Get Yield

I was recently in a group where we were outlining discussion topics for an upcoming conference.  Without fail someone knew someone would mention “generating income in the low interest rate environment”. 

I say without fail because this is always, always, always brought up in settings like this.  I will say however, the conversation has evolved from “what will we do about impending hyperinflation and interest rates rising 1000% overnight” to “how can retirees live off their portfolio income”.

That doesn't mean the conversation isn't worth having.  It is and it’s very important.  However, the one thing that always gets short shrift in the conversation – risk – is equally important.  The idea here is simple – want more yield?  Take on more risk.

This is not to say taking on more risk in order to generate more income isn't the correct decision.  It might be the case; however, the investor needs to realize that there is no free lunch. 

Further, given that rates are extremely low, I could argue the risk is heightened as capital is misallocated.  For example, negative yields on Treasury bonds push more investors into High Yield bonds in a search for yield (remember the extended low rates after Tech bubble). 

This capital flow forces yields down, perhaps well below their fair value.  As a result, if/when interest rates normalize and/or liquidity is less abundant capital could flow the opposite direction, which would force up interest rates on higher yielding assets and lower their value.

I’d like to remind you, this is not a comment on what assets an investor should hold or where interest rates will go, but rather a general discussion about simply this fact: if you want to generate more yield, be sure you realize you are very likely taking on more risk.

What if China Sells All of Our Bonds?

I get these occasionally, “we owe money to China” or “what if China sells off all of our bonds”.

I think the first part is much more complicated than simply “we owe money to China” and can explained walking through why China owes Treasuries:

1. We buy goods from China ABC Co.
2. Before we buy we need to covert dollars to Yuan (CNY), so we sell USD and buy Yuan for the transaction
3. Ultimately the above transaction arrives on the currency market and puts downward pressure on USD
4. We are net importers of Chinese goods; as a result there should be more supply of USD relative to CNY, lowering the value of USD/CNY. 
5. Except there is no downward pressure because China’s Central Bank intervenes and buys those dollars
6. So now what does their Central Bank do now?  They obviously want USD or wouldn’t have purchased it, so they invest in the safest USD asset around – Treasuries.  

That is probably an oversimplification, but what I am getting at is that we “owe” China money due to trade.  Would they sell our bonds?  I don’t know, maybe.  So what?

1. If they are selling, someone is buying.  Given where interest rates are there is plenty of demand. 
2. This would put downward pressure on USD, making our exports more competitive.
3. Given their large holdings of Treasuries, why would China have a “fire sale”?  It would crush exports to their largest (or second largest) customer and harm their own central bank balance sheet.
• Note #1 assumes this is done more orderly than just dumping all $1.5t or so Treasuries on the market.

Again, this is an oversimplification and I am certainly missing a few steps.  Further, I will admit this is above my pay grade.  I am just trying to outline that it is much more complicated than “we owe China” and if they do sell our bonds it could yield positive benefits to our exports.