2008-2020: an era of QE
In the past cycle, central banks have been constantly intervening in the market in order to counter the massive disinflationary/deflationary force coming from the 3D Challenge: Demographics, Debt and Disruption. No only interest rates have remained close to 0 percent (or even negative) in most developed economies, but central banks’ balance sheets have also constantly grown, and it seems that the pace will become more and more rapid as we struggle to get out of this new normal of social distancing and partial lockdowns to fight the pandemic.
Figure 1 shows the evolution of the balance sheets of the top 5 central banks (Fed, ECB, BoJ, BoE and PBoC) in the past two decades. We can notice that in the 12 years preceding the Covid-19 crisis, assets in the major central banks grew by 15 trillion US dollars to nearly USD 20tr, at a very steady pace of USD 1.25tr per year. Hence, as the response to the Global Lockdown, central banks immediately started to intervene in the markets to avoid a massive deflationary shock and limit the downside risks in risky assets such as equities. The pace of assets growth has reached stratospheric levels in 2020; central banks assets have increased by over USD 7.5tr since the start of the year and it does not seem that the trend is about to halt as economies are entering a new lockdown this winter.
Source: Eikon Reuters, RR calculations
In the past cycle, we saw that the annual change in central banks’ assets has been strongly co-moving with the annual change in gold prices, which some economists also refer as the currency of the last resort. Figure 2 shows that the annual growth of central banks’ assets reversed from -1.3tr USD in March 2019 to over USD 8tr in October 2020, levitating the precious metal price from $1,300 to $1,900.
Source: Eikon Reuters, RR calculations
As most developed countries are about to enter national lockdowns in the near term, economies will rely on governments’ assistance, which will simply lead to more QE from central banks. It seems that central banks are running out of options and that policymakers’ only answer to the economic problem will be: print more. Hence, we are convinced that we have just entered the beginning of a long-term gold rally, and we would not be surprised to see an ounce of gold trading at $3,000 within the next 12 months as a consequence of the unlimited monetary policies run by central banks.
Officials cannot afford debt deflation
We know that historically, there has been three major ways to decrease or “get rid” of debt:
- Growth: the most desirable but impossible scenario
- Inflation: the most likely scenario that policymakers are “targeting”
- Partial or total default: the scary scenario
We saw that in the past cycle, financial repression, which targets a yield curve below inflation, has been the most popular strategy to slowly deflate the constant growing amount of debt in the world. The problem is that governments are currently fighting against a massive disinflationary force as we mentioned earlier (the 3D challenge). Hence, despite the major central banks’ constant intervention, inflation is still trading significantly below the 2-percent target.
Figure 3 (left frame) shows that the average headline CPI for the G4 DM economies (Euro, US, UK and Japan) has been oscillating around 1 percent in the past cycle, whereas it was averaging 2 percent between 1998 and 2008. If we look at the core CPI, which is less volatile as it excludes energy and food prices, the aggregate inflation has not traded above the 2-percent target in the past 12 years.
We saw recently that policymakers have been preparing the market that they are ready to let the inflation rate run hot in the medium term, which implies that central banks will not hike the policy rate if we start to see annual changes in core prices reaching 2.5 o 3 percent within the next 12 to 18 months.
Even though participants have been currently talking about the surge in the 5Y5Y inflation swap, which is a market-implied measure of inflation expectations, we previously saw that inflation swaps are very sensitive to changes in oil and equity prices. Figure 4 shows the strong co-movements between oil, equities and US 5Y5Y inflation swap. In theory, LT inflation expectations should not be sensitive to oil shocks as better monetary policy adjustments should offset the shock. Hence, we think that inflation swaps reflect more a demand for inflation hedges rather than a long-term view on inflation expectations.
We previously saw that views on inflation are mixed: there are a number of practitioners and academics who think that inflation will surprise the market sooner than investors think, while others are simply predicting a constant deflationary pressure in the next three years.
However, one thing that we are convinced in the near to medium term is that the restrictive economies will constantly rely on governments’ assistance, which implies more interventions from central banks, leading to more money into the system and therefore to higher gold prices. Even though a deflationary environment should be negative for gold, the market will directly start to price in more liquidity injections, which we think will strongly support the price of some assets with limited supply (gold, silver or even Bitcoin).
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Disclosure: I am/we are long USDCHF, EURGBP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.