When the euro was launched, the European Central Bank (ECB) held approximately 15% of its assets in gold. That ratio has remained reasonably stable, giving rise to a variety of chatter, including suggestions that it may displace the U.S. dollar. We pursue the question on whether the ECBís gold holdings are an accident or strategy.
Letís look at the numbers. Below is a chart depicting the percentage of gold relative to the ECBís total assets. As one can see, the percentage has remained reasonably stable despite a significant growth in total assets.
Total assets of a central bank may be considered a proxy for the amount of money that has been ďprintedĒ; itís a crude measure as it does not reflect physical money printed; nor does it reflect money in circulation; neither does it reflect sterilization activities that also show a rise in assets. Still, a central bank balance sheet is often referred to as the printing press as money is literally created out of thin air (by the stroke of a keyboard) when assets are purchased. Federal Reserve (Fed) Chairman Bernanke has referred to this fiat money feature as the printing press. We like to think of it as super-money, as central bank purchases provide cash to the banking system, allowing them to lend a multiple of the money that has been ďprintedĒ. While banks have been reluctant to lend (the velocity of money has been low), the analogy we like to give is that if you give a baby a gun, just because no one gets hurt does not mean it is not dangerous. That said, letís look at total assets at the ECB:
The interpretation shows that while money can be printed, wealth cannot be created out of thin air: as money is printed, gold has appreciated versus the euro. So while inflation has not shown up in indicators such as the Consumer Price Index, monetary easing is rightfully reflected in the price of gold.
Diving a little deeper to determine how much of this is strategy versus accident, letís look at the gold holdings at the ECB once more:
The ECB marks its gold holdings to market, i.e. uses market prices for gold. The ECB was selling gold from the inception of the euro until the onset of the financial crisis; since then, the ECBís gold holdings have remained stable. To understand the motivation, one needs to note that when one refers to ECB gold holdings, one is actually talking about Euro area gold holdings. While the ECB holds some gold, most gold is held by the respective central banks (this is not a discussion of where such gold is physically located):
Relevant is that each nation in the Eurozone pursues its own agenda with regard to its gold holdings. Germany has resisted political pressure within Germany to sell gold, as Bundesbank (Buba) profits would need to be transferred to the government; the hawkish Buba has indicated that it would be considered selling gold to help finance the governmentís deficit. Italy, as one can see, has not sold any gold. Conversely, as a percentage of their holdings, the Netherlands had been rather eager to sell gold up until the financial crisis; Portugal, too, was an aggressive seller. As one can see, gold sales are not particularly related to the financial health of a Eurozone nation, but more to the cultural attitude in the respective nations towards gold.
Letís cross the Atlantic to see whether the ECBís gold strategy is undermining the U.S. dollar. The Fedís gold stock is valued at $44.22 per fine troy ounce. For purposes of the chart below, we adjust the Fedís gold holdings to market prices:
Note that the chart above starts in 2006, so as to focus on the period of the financial crisis. The Fed has been more aggressive than the ECB in printing money. As such, the percentage of gold in relation to total holdings has declined at the Fed in a more pronounced fashion. There is clearly no perfect relationship between the size of the balance sheet and the price of gold, as other factors also influence the supply and demand of gold; however, increasing the supply of fiat money (dollar, euros) may decrease its value when measured in real assets, such as gold. We have in the past referred to the Fed as the champ in printing money (as measured by the percentage balance sheet growth since August 2008), although the Bank of England has, as of late, taken on that title. But we digress.
From what we see, central banks have been scared into holding gold since the onset of the financial crisis. Beyond that, we donít see an active strategy at the ECB to keep its gold reserves at 15% of total assets. Instead, the ECBís comparatively measured approach has simply lead to a reasonably stable percentage of gold reserves. Of course that was before ECB President Draghi said on July 26, 2012, that he shall do ďwhatever it takes to preserve the euro.Ē (an interpretation of that may be that more money printing is on the way). For now, the cultural differences in responding to the financial crisis (Europe: think austerity; US: think growth) suggest that the euro should outperform the U.S. dollar over the long term, assuming the not-so-negligible scenario of a more severe fallout from the Eurozone debt crisis wonít materialize.
It may help to keep in mind that historically inflation is the response to a deflationary shock. If market forces were left to themselves, we believe the credit bust of 2008 would have caused a major deflationary shock. Itís the reaction of policy makers that fight market forces that may lead to inflation. Bernanke as of late brushed off such pessimism. As the charts above show, however, gold has been a sensitive Ė and sensible I might add - indicator to the trigger-friendliness of our central bankers.
We have long argued that investors may want to take a diversified approach to something as mundane as cash. Please sign up to our newsletter to be informed as we discuss global dynamics and their impact on currencies. Please also follow me on Twitter to receive real-time updates on the economy, currencies, and global dynamics.
Axel Merk President and Chief Investment Officer, Merk Investments Merk Investments, Manager of the Merk Funds
The Merk Hard Currency Fund is a no-load mutual fund that invests in a basket of hard currencies from countries with strong monetary policies assembled to protect against the depreciation of the U.S. dollar relative to other currencies. The Fund may serve as a valuable diversification component as it seeks to protect against a decline in the dollar while potentially mitigating stock market, credit and interest risksówith the ease of investing in a mutual fund.
The Fund may be appropriate for you if you are pursuing a long-term goal with a hard currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Fund and to download a prospectus, please visit www.merkfund.com.
Investors should consider the investment objectives, risks and charges and expenses of the Merk Hard Currency Fund carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Fund's website at www.merkfund.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.
The Fund primarily invests in foreign currencies and as such, changes in currency exchange rates will affect the value of what the Fund owns and the price of the Fundís shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. The Fund is subject to interest rate risk which is the risk that debt securities in the Fundís portfolio will decline in value because of increases in market interest rates. As a non-diversified fund, the Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. The Fund may also invest in derivative securities which can be volatile and involve various types and degrees of risk. For a more complete discussion of these and other Fund risks please refer to the Fundís prospectus. Foreside Fund Services, LLC, distributor.
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