It is amazing to many people how the economy of Britain which makes up less than four percent of global GDP can roil world markets and potentially even derail the world economy itself. The overwhelming majority of individuals on the planet do not care what the U.K.’s trade ties with the remainder of the EU will look like years after Brexit. Yet the British choice to leave behind the European Union is aggravating several interrelated forces that were already threatening the world financial stability and strengthening gold prices in the process.
Lower Inflation a Threat
Global commodity supply and tepid demand have led to a glut among commodities, especially oil. Labor is also overly available as demonstrated by the higher unemployment plaguing many regions of the earth. This all comes amidst inflation that is consistently lower than two percent level which central banks find desirable. Brexit has only made these forces worse. Oil plunged 7.5% between the closes of Thursday and Monday on potential declines in worldwide demand over growing uncertainty. Inflation that is too low actually discourages businesses and people from investing and spending and makes sovereign debt burdens heavier. The U.S. bond market now predicts yearly inflation of only 1.37% through 2026. Germany and Japan’s inflation expectations similarly show drops of .13 of a point and .10 of a point since the Breit referendum. All of these development are positive for gold prices, as uncertainty and lower competing interest rates underpin the safe haven metal.
More Negative Global Outlook
The U.S. dollar index has risen over 20% in the last two years. It is not gaining on the progress of the U.S. economy, but rather on a negative worldwide outlook. Economies in Europe, Japan, and developing markets still look incredibly weak more than five years after the end of the last financial crisis and Great Recession. This makes the U.S. look strong by comparison. The higher dollar creates problems for the U.S. though. American exports are more expensive and less competitive, harming the abilities of multinational American companies to sell products abroad and hurting U.S. growth prospects. Brexit is making this worse as the dollar has risen more than three percent from last Thursday. Though the British pound’s collapse is the main culprit, the euro and yen are similarly down.
Ineffective International Monetary Policy
The frustrating part is that the important global central banks have been trying with few results to fight these economically negative forces. Both the Bank of Japan and European Central Bank are busy pumping enormous amounts of money into their banks by purchasing assets. The Bank of England and Federal Reserve in the U.S. have held off on long anticipated interest rate increases to try to improve growth and reach higher inflation levels. All of this has been to no avail as Brexit results showed. Financial markets and experts are now looking for possible interest rate cuts instead of raises from both the Fed and BOE. The Bank of Japan and the ECB are already talking about even more quantitative easing programs in the coming weeks and months.
Continued Lower Interest Rates Demonstrate Fear Premium
Ten year Treasury bonds’ interest rates in the U.S. declined from 1.74% on Thursday to 1.44% by Monday’s close. Longer term interest rates like these are also on the decline throughout Europe and Britain. Switzerland, Germany, Denmark, and other European nations now have long term interest rates that are negative. Buying and holding these bonds guarantees the investors will lose money. This reflects more than just investors’ anticipation that central banks will continue to intervene. It centers on the fear premium where investors will park their money in any safe haven asset including ones that promise a loss. Gold has no negative interest rate as part of its absence of yield, making it more attractive than these negative rate bonds.
Weaker Growth Underpins All of these Problems
The ultimate factor that has contributed to all of these other problems is that global growth is now substantially weaker than before the 2007/2008 financial crisis and Great Recession. Nearly ten years after the crisis began Europe has only now attained its 2007 economic output levels. Japan continues to slide in and out of recession. Chinese growth is slowing while Brazil is mired in recession. The U.S. and Britain may be outperforming, but this is only measured against the lower standards that have been set since the 2000’s. The Brexit vote looks likely to decrease the unimpressive growth around Europe and the rest of the world even more. The longer the uncertainty around European trade ties and the British economic future goes on, the worse this will get.
Britain Suffers from Double Sovereign Credit Downgrades While Gold Forecasts Rise
The S&P took the unprecedented step of cutting the British AAA credit rating by two notches at once in the wake of the Brexit vote chaos that has unfolded. Fitch also downgraded their credit rating and outlook for Britain on Monday. All of this is good for gold’s outlook and has already been reflected in several prominent investment banks increasing their gold price forecasts. Morgan Stanley has increased its 2016 price predictions by eight percent and 2017 targets by thirteen percent. Goldman boosted the three, six, and 12 month price targets by $100 per ounce in light of the continued flight to safe haven assets that is ongoing.
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