A consumer price inflation rate of almost 7 per cent mark should worry all households. But it should also be a concern for investors – especially those investing in fixed income instruments.
It also presents a chance for gold lovers to load up on investments in the yellow metal. An important reason behind it would be the falling real rate of interest. Along with other factors, real interest rates influence the demand for gold and, in turn, affect gold prices.
The real interest rate is calculated by deducting inflation from the nominal rate of interest. For example, if a bond offers 6 per cent interest and inflation stands at 4 per cent, then the real rate of interest is 2 per cent (6-4=2).
Real interest rates and bond returns
When real interest rates are positive, they compensate investors for foregoing their current consumption. A positive real rate of interest encourages investors to invest in debt securities. Generally, investors are compensated by offering them positive real interest rates.
But there are situations when the real interest rates get to zero or even negative terrain. However, as the real rate of interest goes down, buying bonds does not remain attractive. Debt investments in times when the inflation surpasses the bond yields, do not protect the purchasing power of the investor.
Liquidity impacts interest rates
Central bankers across the globe have cut interest rates. They have infused liquidity in the financial markets to fight COVID-19’s economic impact. This has led to a further fall in interest rates. As supply chains got disrupted, the prices of many commodities increased – raising inflation numbers. Too much money infused in financial markets hint at sustained inflation the in near future.
Inflation numbers surpassed yields. The real rate of interest has turned negative. India is no exception. As per a recent SBI Ecowrap report, real rates of interest have been negative since December 2019, barring in March 2020.
If we deduct 5.25 per cent rate of interest on a bank fixed deposit from the CPI of 6.93 per cent, we get real rate of interest of minus 1.68 per cent.
In search of returns
Negative real rates push investors to shift to risky assets such as equity and also gold in search of returns. By investing in gold, the investor is willing to lose out on the bond interest income she would have earned had she invested in a debt security. But in the wake of negative real rate of return from debt funds, she is more likely to choose gold over bonds. “Gold is nothing but a perpetual zero coupon bond, which maintains the purchasing value of any currency simply because it cannot be printed at will unlike government bonds which can have unlimited issuances,” says Ritesh Jain, former fund manager and blogger at WorldOutOfWhack.com.
Gold is perceived to be a safe-haven asset. At a time when the real interest rates are negative and there isn’t much of clarity on corporate earnings, there is a fair chance that investors may embrace gold.Investors, however, must understand that other than negative real interest rates, there are many other triggers for yellow metal prices to move northwards. Consumption demand – the key driver for gold, is down as individuals across the world are trying to make peace with the uncertain environment around. However, the same uncertainty is expected to propel the safe-haven demand for gold.