Mourtaza Asad-Syed is an independent strategist who has just published Gold Investing Handbook, a book that analyzes the factors that determine the price of gold. With 20 years’ experience in finance as an economist, chief strategist, and portfolio manager, he is President of ISAG, the Association of Investment Strategists, which brings together the 20 leading banks in Geneva. For BSI Economics, he discusses the upcoming Swiss referendum on November 30, 2014, and its possible consequences for the financial markets, as well as the significance of this unprecedented consultation.
BSI Economics: On November 30, 2014, the Swiss will be asked to vote on the Swiss National Bank’s balance sheet management, which is guided by gold repurchase programs. What lessons can be learned from this mobilization?
Mourtaza Asad-Syed: This referendum—which proposes significant constraints on the composition of the SNB’s assets—is above all the first popular challenge to an OECD central bank following the exceptional monetary actions that have become commonplace since 2008. The main conclusion to be drawn is that there is popular demand in Switzerland for greater accountability from the monetary authorities.
Ironically, the SNB’s policy has been a success for years and, for over a century, the SNB has had the best track record in the world in terms of price and currency stability. If, despite this context, Swiss central bankers are being called upon by democratic representatives, then this popular demand must necessarily be even more acute in other regions where direct democracy is less accessible, such as in the eurozone. Switzerland is therefore a good indicator of public opinion, as referendums require more than 100,000 signatures, which is not insignificant out of a total of 5 million voters. Beyond Switzerland’s borders, this vote should therefore raise questions about the actions and status of monetary authorities, as a popular reaction is to be expected in a context of lack of understanding and acceptance. The legitimacy of central banks to pursue exceptional policies could then be called into question, particularly in the event of a probable failure to stimulate economic activity. The risk of populism or radicalization will only be higher, because if these questions are not answered seriously, the wrong answers will be given. The three proposals in the initiative are an example of this.
If the vote is successful, what would be the difficulties in implementing this gold purchase program?
MAS: The initiative makes three proposals: the first is to buy gold amounting to 20% of the SNB’s balance sheet, the second is to define gold reserves as inalienable by prohibiting the right to sell them, and the third is to keep this gold in Switzerland. The second proposal is not reasonable for a monetary institution such as the SNB.
Given the size of the SNB’s balance sheet, which has increased fivefold in ten years, buying back gold equivalent to 20% of the balance sheet would mean buying back nearly 2,000 tons, or more than two-thirds of global annual production. This level may seem negligible in view of the flow of transactions on the financial markets, but this is physical gold and not just futures or scriptural money, which accounts for the bulk of transaction volumes. Historically, acquiring 1,500-2,000 tons of gold is a significant undertaking, but if spread over five years, it remains in the same order of magnitude as what central banks had bought or sold in previous periods. Accumulation and storage in Switzerland remains very feasible, as the country is still the hub of the gold trade, accounting for 70% of global refining. However, by being highly visible and constrained in its gold repurchase policy, the SNB will be subject to arbitrage by major market players.
The ban on selling previously acquired gold poses a real sustainability problem for the SNB. Any temporary increase in the balance sheet leads to gold purchases, which cannot be reduced once the balance sheet has been cleaned up. As the SNB increases its balance sheet, the share of gold will tend to grow. For example, with the current balance sheet of CHF 522 billion, the SNB would have a gold share of CHF 104 billion. From a balance sheet reduction perspective, CHF 104 billion becomes a new minimum. If we return, for example, to the pre-crisis size of around CHF 120 billion, gold would represent 90% of reserves and could not be used by the SNB for intervention (even to defend the currency). It is clear how quickly the SNB would find itself under enormous pressure, like a car without reverse gear: you can’t see the difference when you’re moving forward, but it’s impossible to maneuver…
What would be the impact on gold prices and foreign exchange markets?
The impact should be slightly positive on gold, but we will mainly see a sharp appreciation of the Swiss franc, which the SNB will find difficult to stem with the new balance sheet constraints. Gold prices will rise automatically if the 1,500-2,000 tons are purchased quickly, but if the program is spread over five years, it will be more a case of small arbitrage transactions, with each new purchase by the SNB having a temporary impact on prices.
With the first two proposals in the initiative, the SNB will not be in an ideal position to defend a weak parity against the euro. As exchange rate policy is dependent on the proportions defined in the balance sheet, each euro purchased will require the purchase of 25 euro cents (25 = 20% (1+0.25)). This is a difficult situation that requires balancing flexibility and intervention in the foreign exchange market while neutralizing the impact on the central bank’s balance sheet. This is where the SNB will now be very vulnerable, as the floor against the euro is maintained thanks to the credibility of the threat of unlimited action by the SNB, but the constraints on irreversible gold purchases for each SNB intervention undermine the credibility of « unlimited action. » The acceptance of the initiative will therefore have more impact on the CHF than on gold!
What are the main dynamics affecting the price of gold?
Gold must be analyzed in three ways: first, gold as a financial asset; second, gold as a currency linked to real interest rates; and finally, physical gold, which can be used to tell many stories but ultimately explains very little.
The price of gold is going through a rough patch. The US economy is in a traditional expansion cycle, which is reflected in the expansion of stock valuation multiples (editor’s note: higher prices relative to earnings). The volatility of nominal and real growth remains low but stable. This uncertainty surrounding economic indicators is a huge factor against gold as an asset. Relatively strong growth coupled with the absence of inflation is everything that gold hates.
On the other hand, there has been a paradigm shift in access to liquidity. The reduction in the US oil bill is helping to reduce the amount of offshore dollars for the populations concerned. These are either Russians or Middle Easterners, whose preferences for gold in terms of assets differ from those of Americans and Europeans. Their asset allocation, which is more focused on commodities and non-bond assets such as equities, leads them to take more discretionary action, causing them to become « market makers » when it comes to investing their surplus reserves. Thus, the decline in energy prices and the rise in other strategic expenditures (particularly for Russians) are leading to a reduction in gold transaction flows, which is negatively impacting prices. We observed this phenomenon with negative plateaus in gold in 2013, coinciding with a decline in revenues for Asians, Middle Easterners, and Russians.
What is the link between real interest rates and gold prices?
In principle, the cost of holding gold, which secures purchasing power, is measured by the real interest rate. Thus, a decrease in the real interest rate is accompanied by an increase in the price of gold. Similarly, any economy whose real interest rate appreciates will see the price of gold, expressed in that currency, decrease. Five- to ten-year maturities are the most closely followed and best explain the arbitrage differences between currencies and, indirectly, the link between real interest rates and gold.
However, I am quite surprised by the US bond market, which should be at higher levels in terms of interest rates given the expansion of US stock valuation multiples. The real rate component should have increased, which is not the case, unlike gold, which seems to be well valued relative to the equity market. From an economic cycle perspective, real interest rates should be rising. This is not the case.
Does the evolution of the gold price reflect uncertainty about the economic outlook?
Gold outperforms the stock market when economic volatility increases and underperforms when it moderates. The trade-off between equities and gold therefore boils down to a structural bet over five years: are we returning to a period of economic moderation (as currently observed given the volatility of inflation and GDP), or are we returning to a period of volatility with short economic cycles?
The price/earnings ratio of a stock or market does not reflect economic growth potential, but rather the potential for certainty about a certain level of profit growth. If tomorrow becomes more predictable, then equity markets will be revalued upwards. For example, the companies with the highest price-earnings ratios are not those with the strongest growth, but those with the most stable growth. It is this relationship that allows us to interpret the arbitrage between equities and gold over a 3- to 5-year horizon.
US multiples value stable and positive growth in the US economy, while real interest rates value no economic growth. Gold is currently underperforming equities, which should translate into higher real interest rates. There is a striking contradiction.
Could gold play a central role in the international monetary system?
The role of gold depends on citizens’ need to appropriate their currency, i.e., its use. In 1944, Keynes proposed a gold banking system, which was ultimately replaced by the gold standard system, which turned out to be an American rent. The US dollar allows the American economy to generate additional income equivalent to 2-3% of its GDP (see « Exorbitant Privilege » by Hélène Rey and Pierre-Olivier Gourinchas), due to the use of the US dollar by other countries as a reserve currency and as a benchmark for risk-free assets. As a result, the United States has an external income balance in its favor, despite a structurally negative current account balance. Its debt generates additional income! The opposite is true in Europe. Giving gold a central role as a risk-free reserve/reference currency would deprive the United States of this reserve currency rent. This is therefore unlikely to happen. Furthermore, the reserve currency is the one that enables trade and financial transactions, and it would be rather inconvenient to settle contracts and transactions in gold…
What would be the risks associated with a successful vote by the Swiss on November 30?
If the Swiss vote is successful, it is not so much the role of gold that will be renewed, but rather the disappearance of the Swiss franc that will be at stake. The SNB would then be the only central bank to hold a « quasi-gold currency. » The currency could then lose its usefulness as citizens may well turn away from it for their transactional needs. Swiss exporters, employees, and consumers will be forced to switch to the euro for practical reasons, as the franc will have a very volatile parity.
Above all, the issue of monetary independence must be examined. Price stability and central bank independence are concomitant events, and a causal link has been inferred. But ultimately, it is the strength of institutions—monetary authority, but also executive, legislative, and judicial power—that promotes price stability, with independence being only a means to that end. Switzerland is raising the question of the trade-off between democratic control, institutional strength, and central bank independence. The value of a currency depends on how citizens use it, and they need to get involved in this debate because a population can turn away from its currency. We are still a long way from this situation. But what is remarkable is that the Swiss central bank has the best track record over the last 100 years in terms of price stability and financial stability. Yet it is in Switzerland that questions are being asked. This shows the need for lively debate on this subject in other places.
The debate on whether or not central banks’ policies are legitimate is only just beginning in the OECD. Indeed, an interesting phenomenon, particularly visible in the United States, moderately so in the eurozone and to a lesser extent in Switzerland, concerns the redistributive impact of zero interest rate monetary policies. When rates fall, savers see the profitability of their capital decline in favor of other objectives such as employment or monetary stability. In the context of the Federal Reserve’s reflation objective, for example, there is a phenomenon of redistribution: savings become under-remunerated and encourage economic agents to take on more debt, mainly to enable them to buy back their shares or engage in private equity, LBOs, etc. However, the working classes are more « cash-oriented » (current accounts, savings accounts, passbook accounts, etc.) and less inclined to invest in riskier assets, with shares being held mainly by the wealthiest 10% or even 1% of the population. This sleight of hand by central banks, redistributing wealth from the poorest to the wealthiest, is not insignificant (in France, a 1% reduction in Livret A savings accounts represents a loss of $2 billion in income for households) and is carried out without a political mandate.
Switzerland is therefore questioning the legitimacy of the central banker in terms of monetary and financial stability, which is a major issue, but also in terms of his relationship with economic and fiscal policy, which is largely subject to democratic control. However, this secondary issue tends to take precedence over the primary one. Janet Yellen and the Federal Reserve sometimes seem to ask themselves this question, since the effect of quantitative easing on boosting employment among the working classes is not a certainty for the board, while its effect on redistribution, which increases inequality, is indisputable.
