When the Reserve Bank of India’s Governor Shaktikanta Das spelt out the monetary policy and said the MPC has decided to continue with the existing repo rate at 4 per cent and to adopt an accommodative stance, the old school fixed income investors looking for a bit higher rate of interest on their small savings lost hope for the time being. Though experts expect some amount of tightening of liquidity in the second half of the financial year leading to somewhat higher interest rates, if inflation does not ease it will remain a tough time for fixed interest investors.
However, there is a flip side to this. Sometimes a move in one asset class makes some other asset class look attractive or make investors run away from the other asset class. One such readily available investment option is gold. One of the key drivers of gold prices nowadays is the negative real yields on bonds in a low interest rate regime. Let’s see how it works in favour of gold.
Real yield is defined as the nominal rate of interest minus the rate of inflation. So if you have a bond or another debt instrument paying interest at the rate of 6 percent and inflation is recorded at 4 percent, then the real yield stands at 2 percent. When investors invest in debt, they postpone their present consumption needs for getting that coupon rate. The idea is to get compensated for delaying consumption. No wonder, the long term rate of interest should ideally be in excess of the rate of inflation.
Though this logic seems right, in the real world of investment the situation may be far different. There are times when the rate of inflation exceeds the interest rate payable on bonds. For example, the 10 year US government bond yield stands at 1.55 percent compared to inflation print of around 4.2 percent. In India, the inflation is projected around 5 percent and bank fixed deposits are mostly offering around 5.25 percent. Post tax yields are far lower depending on the tax bracket of the investor. Put simply, you are penalised if you decide to save and invest in a fixed deposit.
Not all investors in this situation can go for investments in equities, but at the same time want to protect their purchasing power. Herein gold investment comes to the rescue. The opportunity cost of owning gold is the next best alternative which is investing in a bond or a bank FD. And if that rate of interest – or the real yield on that bond goes down, or turns negative, then it makes a lot of sense to change tack and invest in gold.
When the central bankers all over the world decided to unleash liquidity, infuse funds in the financial system and cut interest rates, the real yields have gone down with minimal gains for investors. Gold, on the other hand stands to and is bound to find more takers in the investor community. In fact, gold prices have been steadily inching up again in the past few weeks. In the first leg of Covid-19 pandemic the liquidity unleashed and the interest rate cut led to low real yields. That pushed up gold prices. However, gold gave up its gains in subsequent months and slid sharply in 2021. As economic recovery gathered momentum and the liquidity support started waning.
The next leg of support to gold prices is seen in the form of sticky inflation. Inflation – especially the commodity inflation hits the commodity consuming emerging economies including India. It should keep the real yield low and add to investment demand for gold. There is also the likelihood of a fresh round of liquidity infusion by central banks and government as stimulus measures around the world, which may further hike inflation and prop up gold.
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