Derivatives: The $563-Trillion Reason to Look at Gold

Reason to Look at GoldInterest rates in the U.S. economy have been remarkably low since 2007. We’re now hearing many analysts and pundits suggesting they will rise sometime this year. Unfortunately, there isn’t an exact time given, but when we look to the Federal Reserve, it seems very adamant about it, too.

Officials at the Federal Reserve are continuously warning that higher interest rates are coming. The most recent example would be the comment from the president of the Federal Reserve Bank of Cleveland, Loretta J. Mester. Regarding raising interest rates, she said, “I want June to be a viable option.”(1)

If the Federal Reserve does go ahead with an interest rate increase, there will be major consequences. (And this will only lead to good news for gold and gold-related investments. But more on that and the $563-trillion threat that’s positive for gold shortly…)

U.S. Bond Yields Heading Upward

Looking at the bond market, it doesn’t look like its ready for a hike in interest rates. In fact, it is doing the complete opposite—bond yields are declining, suggesting interest rates will remain low or go down even further. Please look at the chart of the U.S. 30-year bond yield below.

STYX 30-Year T-Bond Yield INDX

Chart courtesy of www.StockCharts.com

The yields on the long-term U.S. bonds are currently sitting near the same levels they were at back in 2009. Economics 101 tells us that when there’s the expectation that interest rates will rise, the yields on long-term bonds usually soar. It seems as though that’s not happening this time, though.

Paying Attention to the Derivatives Markets

If the Federal Reserve does raise interest rates—from its statements and wording from officials, it would suggest the Fed might just do it—there’s a risk that is being ignored. What’s that risk? Interest rates are linked to the derivatives market.

Derivatives are securities that are essentially contracts between two parties; the values of these contracts fluctuate with the value of the underlying assets. An example of a derivative would be a call option on a stock. As a stock’s price declines, the price of call options increase.

As of June of 2014, there were interest rate derivatives with a notional value of $563 trillion! (This is not a typo.) The gross market value of these securities was $13.41 trillion.(2)

To give you some perspective on how big this $563 trillion number really is, consider that in 2013, the global gross domestic product (GDP) was $75.59 trillion. This is the GDP of all countries (except a few smaller nations) added together.(3) In other words, the notional value of interest rate-linked derivatives is more than seven times the global GDP.

If interest rates fluctuate, these derivatives will fluctuate as well. And, this phenomenon can result in a significant amount of uncertainty. This is something that shouldn’t be overlooked. It has the potential to shock the financial system, and its extent could be more hostile than the financial crisis of 2008 and 2009.

Gold in Light of Rising Interest Rates

It is often believed that when interest rates rise, gold prices slide lower. The recent decline in gold prices can be slightly blamed on this, but I’m looking at gold differently.

Consider this: if interest rates rise, it will not be surprising to see currency markets fluctuate significantly. Stocks will face headwinds as well. Add those interest rate-linked derivatives to the picture, and you will have a significant amount of uncertainty at hand.

Going forward, I expect fluctuations in the gold market. There’s a strong belief among investors that the deflation will come into play and interest rates will rise; these investors are selling gold. Looking at all the risks building up, this may not be the case and that may not be the right move.

I reiterate again: investors should be looking at gold as an insurance policy on their portfolio. Going all in would be a mistake, but having some exposure to the precious metal wouldn’t hurt. Gold works during times of uncertainty and we may be headed that way right now.