 Real Rates and
Gold 8
Adam Hamilton
Archives
March 26, 2005
This week witnessed some big news on the real interest rate front.
Notable developments hit the wires in both key components of
real interest rates, nominal 1-year US Treasury Bill yields and
the annual growth rate in US inflation as measured by the Consumer
Price Index.
On Tuesday the US Fed raised
overnight lending rates between banks by 25bp to 2.75%. It was
the seventh consecutive 25bp rate hike in as many FOMC meetings.
Bonds were sold on the higher-rates announcement, driving yields
higher. The benchmark 1y T-Bill yields instrumental in real-rate
calculations headed up near 3.5% on the Fed's action.
The FOMC even made the following
statement about inflation, which is pretty extraordinary since
it usually does everything possible to convince the markets that
inflation is trivial. "Though longer-term inflation expectations
remain well contained, pressures on inflation have picked up
in recent months and pricing power is more evident."
The "pricing power"
reference refers to the fact that US corporations are growing
tired of eating higher raw
materials costs. They are ready and able to simply raise
their final-goods prices to American consumers and pass on these
higher general costs. If the rising costs are not passed through,
corporate profits and US stock prices will suffer.
But as soon as corporations
exercise their pricing power to pass along their own higher costs,
American consumers are going to start feeling the pinch of inflation.
Each dollar earned will buy less and less in terms of real goods
and services. This will hit folks who live from paycheck to paycheck
especially hard. The latest CPI numbers released the morning
after the Fed's rate hike are already bearing this out.
The February CPI report claimed
US consumer prices rose a staggering 0.4% last month. Annualized,
this means that general prices in the US are growing at a hefty
4.8% a year, even by the lowballed official government measure.
In absolute terms, the latest CPI data weighed in at a 3.0% higher
level than that of a year ago.
Recall that real rates are
simply the nominal interest rates savers can earn in the marketplace
less the rate of inflation. To compare apples to apples,
the real rates must be calculated using both components
over the same underlying time frame. If a one-year rate
of inflation is used, then a one-year "risk-free"
US Treasury Bill yield must be incorporated as well to keep the
calculation congruent and accurate.
With 1y T-Bills now yielding
around 3.5%, and CPI inflation running 3.0% over the past year,
real interest rates are now actually modestly positive
for the first time since 2002! Since negative real
interest rates are one of the most bullish monetary environments
possible for gold, this week I would like to continue my real rates and
gold series of essays and address gold in light of these
latest real-rate developments.
With real rates by the most
conservative measure now modestly positive, is our young gold
bull in jeopardy? Will today's newly positive real rates
entice investors out of gold and back into bonds since they can
now once again modestly increase the purchasing power of their
capital through investing in short-term Treasuries?
The short answers are no and
no, so please relax if you are a gold investor. I will attempt
to flesh out the long answers and the logic behind them in the
rest of this essay.
To start, it is easiest to
wrap our minds around this crucial gold and real rates relationship
by first considering the long-term strategic perspective. Since
I wrote my first real
rates and gold essay in July 2001, so much has happened.
The latest update of that original chart published nearly four
years ago tells the whole story of the past 35 years.
Gold is the ultimate money,
but it is also the ultimate alternative investment. Investors
tend to flock to gold not when stocks and bonds are doing well,
but when they are struggling. Stock investors who recognize the
dire writing on the wall relative to the current very high equity
valuations and the long-term Curse
of the Trading Range have been slowly moving capital into
gold to escape the secular bear carnage.
For bond investors, hard times
are not defined by valuation
reversions but by real rates of return. All bond investors
are by definition savers, they have scrimped at some point in
their lives to consume less than they earned so they have accumulated
surplus capital, or wealth. By investing in bonds they make their
surplus capital available to debtors, who consume more than they
earn.
Free-market transactions are
supposed to be mutually beneficial for both the buyer
and seller, or borrower and saver. In normal free markets
where the Fed hasn't manipulated interest rates to artificial
lows, the borrower pays a fair rate to consume more than he earns
and the saver earns a fair rate to consume less than he earns.
Everyone is happy and the bond markets thrive.
But if inflation exceeds the
nominal yields that can be earned in US Treasuries, then savers
actually lose purchasing power by making their surplus
capital available for debtors to borrow. For example, in early 2003
CPI inflation was running 3% while 1y T-Bills were only yielding
just above 1%. If savers lent their capital at this 1% nominal
rate while general prices were rising at 3%, the net result was
they lost 2% of their purchasing power over a year.
Now obviously deploying precious
capital in a relatively risky investment with a guaranteed loss
of purchasing power is pretty foolish. The savvy savers in the
bond markets certainly understand this so they are likely to
gradually defect from bonds when real rates grind too low or
negative. If lending capital via bonds is likely to result in
a real loss, why not just exit from the bond markets and find
somewhere else to protect your purchasing power from inflation?
Enter gold.
As the chart above shows, gold
thrives when real rates are negative, when inflation is so high
or nominal interest rates are so low that bond investors simply
cannot earn a real purchasing-power return with their hard-earned
surplus capital. Rather than let inflation erode their hard work
of a lifetime, they gradually move capital into gold which will
always rise at least enough to keep them ahead of inflation.
Remember that inflation is
always ultimately a monetary
phenomenon. When a central bank creates too much fiat money relatively
more money chases after relatively fewer goods and services driving
up general prices. This very inflating money supply that makes
bond investing pointless also bids up the gold price. Thus buying
gold in inflationary times is as great of guarantee as you can
possibly get that your purchasing power will be maintained and
protected in real terms regardless of fiat expansion.
History has unambiguously taught
that regardless if fiat-currency inflation is running 3% or 300%
gold prices will stay on the crest of this inflationary wave
over the long term. An ounce of gold today will buy roughly the
same amount of real goods and services as it did in 1970 or even
way back in 1910 before the Federal Reserve fraud was foisted
upon the American people.
The longer that real rates
remain low or negative, the longer and more powerful gold bulls
become. It is no coincidence in this chart that today's gold
bull is already the greatest by far that we have witnessed
since the 1970s. The last few years mark the first time since
the late 1970s that real rates went negative, and gold has rallied
higher right on cue as I suspected it would four
years ago when real rates first threatened to go negative
and gold languished in the $260s!
Back to our original question
spawned from this week's news, will the reappearance of modestly
positive real rates threaten the viability of this gold bull?
Highly unlikely. All kinds of interesting strategic comparisons
leap out of this chart above that suggest positive real rates
are not a potential threat to gold until they hit +3% or +4%,
light years away from here in economic terms.
First, note that the 1970s
gold superbull ended in a parabolic spike. This was a one-time
event driven primarily by the final
reneging of the US dollar gold standard in 1971. Today's
bull market is vastly more modest and orderly by comparison.
Gold is rising at a nice steady pace today, not shooting parabolic,
and the public is far from involved. Without a parabolic rise
and a popular speculative mania, today's gold bull is not going
to crash like the 1970s one did.
And if we want to attribute
causality in the early 1980s crash of gold to real rates, note
that they skyrocketed from -6% to +6% on then Fed Chairman
Volker's brutal inflation shock therapy. +6% real rates today
would certainly make the bond markets look sexy again and seduce
capital back out from gold, but the cost to the US economy of
having such high real-rate levels would be staggering.
If annualized inflation is
now running near 5%, in order to get to 6% real we would need
to see the Fed jack up interest rates to nearly 11%! This
would probably push 30y mortgages up to 14%+! With the
US today the worst debtor nation in history and individual Americans
also fielding stunning debt levels, much at adjustable rates,
11% nominal rates would feel like the end of the world.
As fragile as our US debt pyramid
is today, it honestly would not surprise me if 11% fed funds
rates would lead to the end of the Fed if not a popular revolt
against Washington. I suspect bureaucrats who love their taxation
power on the American people would rather eat broken glass than
risk their entire corrupt system by forcing real rates up to
+6%. A repeat of the early 1980s gold crash on stellar real interest
rates seems about as likely as an asteroid slamming into the
Earth.
Actually, in the 1980s and
1990s, real rates seemed to need to hover between +3% to +4%
to make bonds more alluring than gold to savers. When real rates
headed below that gold usually rose, but when real rates once
again stabilized in the 3% to 4% range gold tended to fall. While
I doubt I will see 6%+ real rates again in my lifetime since
they are so disruptive, I am sure we will see 3% to 4% real sometime
in the coming decade or two.
To better understand how real
rates could get to this 3% to 4% level that could start seducing
capital back out of gold, a short-term real-rates chart since
2000 helps clarify the picture. As in our strategic chart above,
the black line represents the nominal 1y T-Bill yield while the
white line represents the year-over-year change in the Consumer
Price Index.
Our current gold bull really
didn't begin in earnest until real rates fell below 1% in early
2001. It is interesting to note that in 2002 when real rates
once again flirted with +1%, gold's bull market didn't show the
slightest signs of abating. This observation leads to two key
factors that will be necessary for real rates to go above +3%
and potentially entice capital out of gold, fantastic economic
pain and realigned saver expectations.
In order for real rates to
get to 3% to 4%, the black 1y T-Bill line above somehow has to
get 3% or 4% above the white annual CPI inflation rate
line. In this latest chart update, I found it intriguing that
the CPI inflation rate is in a technical uptrend with multiple
support and resistance intercepts. If this uptrend holds, as
it certainly ought to the way the Fed is growing money supplies,
then conservative inflation rates are likely to rise by maybe
0.5% per year.
In reality I suspect that this
0.5% annual technical upslope is too flat, and therefore conservative,
for a variety of reasons. The February CPI report just released
showed annualized inflation running nearly 5%, far above the
3% growth in the CPI over the past year. Over the past year true
inflation, pure money supply growth, was running 5.0% in the
broad US M3 money supply, two-thirds higher than the past year's
CPI numbers.
For students of the markets
studying inflation, we have to remember that the CPI is not
an unbiased dataset like the price history of some stock. The
CPI is computed internally by the US government and uses hedonic
adjustments and all kinds of mathematical wizardry to intentionally
lowball the results for political reasons.
Many welfare programs today
like social security are indexed directly to the CPI which means
that the higher the CPI the more of our taxes the government
has to pay out to the welfare recipients. These welfare payments
are non-discretionary, they must be paid, and the larger they
grow the less discretionary money Washington has to spend on
"fun stuff" it likes such as imperialism abroad and
suffocating regulation at home. And we all know that bureaucrats
and politicians just live to waste our money so they are not
happy at all if the CPI grows too fast driving welfare payments
to cut into formerly discretionary funds!
So the CPI is heavily massaged
by the bureaucrats that create it to make it as benign as possible
for their political masters. Nevertheless, even with all the
hedonic-type gimmicks thrown at it, it is still rising. In order
for real rates to once again challenge the 3% to 4% level that
may start enticing capital out of gold, nominal 1y T-Bill yields
have to rise enough to get 3% or 4% ahead of CPI growth.
If the CPI proves to be running
at 5% growth a year from now as the February CPI report suggested
the annualized inflation growth rate now is, 1y T-Bills would
have to yield 8% or 9% to catapult rates up to 3% to 4% real.
8% to 9% nominal risk-free rates, however, would not be easy
to get to and would cause staggering pain for both overvalued
US stocks and overextended American debtors.
The fed funds rate was hiked
to 2.75% this week, and it would have to triple again
from here to be high enough to push 1y rates up to 8% to 9%.
A 7.5% to 8.5% fed funds rate would gut the stock markets like
a fish and probably lead to bear-market downlegs that would utterly
dwarf those of 2001 and 2002. Economists generally consider a
fed funds rate of 4.25% or so to be neutral, so a 7.5%+ fed funds
rate would be highly constrictive and cause debt and asset prices
to contract dramatically across the entire US economy.
American debtors
would be crushed like bugs, especially all the fools today who
were naïve enough to take out adjustable-rate mortgages
and other loans near half-century nominal interest-rate lows.
Debtors who willingly took this adjustable-rate risk make professional
options speculators look like risk-adverse cowards by comparison.
At 8% to 9% 1y T-Bill yields
I suspect 30y mortgages farther out on the yield curve would
cost 11% to 12%. If Americans tend to be overextended today with
5% mortgages, they would be toast with 10%+ mortgages. Such stellar
rates would almost certainly crash debt-financed speculative
real-estate markets around the country, with 90% price plunges
in speculative houses probable.
Now this certainly isn't rocket
science and the Fed knows it too. If getting to +3% to +4% real
means jacking up mortgage rates to 10%+ and crashing the housing
bubbles springing up across our great nation, I bet the Fed will
do anything in its power to avoid raising rates that high, including
letting the dollar bear market continue unabated which is hugely
beneficial
for gold.
With American consumerism now
driving two-thirds of the US economy, and debt driving the majority
of this consumerism, any major rise in interest rates risks triggering
a full-on depression, the first in three generations. Depressions
are exceedingly dangerous events for existing governments
as they trigger all kinds of social unrest which can lead to
major government changes. The politicians and bureaucrats at
the helm today will probably do everything they can to avoid
threatening their cushy status quo.
And practical pain aside, there
is a crucial expectations component as well that not even
the mighty Fed can ever hope to manage. In the markets, expectations
can be far more important than reality. Even the Fed's statement
on inflation I quoted above in the introduction explicitly mentioned
inflation expectations.
If real rates could somehow
get to +3% to +4% without causing enough chaos in the debt-ridden
US to spark the next Great Depression, these rates would have
to stay high enough for long enough to convince bond investors
that they are likely to persist indefinitely. If real
rates merely shot up and were expected to promptly crash back
down to 1% or less, then there would be no reason for bond investors
to move capital back out of gold and into bonds.
So not only do real rates need
to head to 3% to 4% to seriously threaten this powerful gold
bull, but they would have to stay there long enough to convince
flight capital that the ruthless Greenspan assault on savers
was finally over for good. I don't know how long real rates would
have to remain healthy to reset expectations, but I suspect we
are talking in terms of years here after +3% to +4% real
is first witnessed.
To summarize, low and negative
real rates drive great gold bulls since bond investors can't
earn any real returns on their capital. In order to entice inflation
flight capital back out of gold, real rates have to rise
back up to 3% to 4% and stay there long enough to convince savers
to expect these favorable conditions to persist. But if
the Fed pushes nominal rates high enough to hit 3% to 4% above
inflation, then it risks collapsing the entire US real estate
market and hobbling two-thirds of the US economy.
Today's newly positive real
interest rates, now running near 0.5%, are nowhere close to high
enough to reverse the trend of capital migrating from bonds to
gold. Not only are today's anemic real rates only 1/8th to 1/6th
high enough to be healthy again, but they haven't persisted anywhere
close to long enough to set expectations that a pro-saver real-rate
environment is once again returning.
The Fed will have to raise
rates far more than it already has to even approach healthy real-rate
levels that could seduce inflation flight capital back out of
gold. Since this will probably take years, we will continue to
actively trade this secular gold bull via carefully researched
gold-stock trades in our acclaimed monthly
newsletter. Please join
us today to stay abreast of our latest actual gold and silver
stock trades and trading strategies.
Today's new modestly positive
real rates are certainly interesting, but odds are they are nowhere
close to being worthy of fear for today's gold investors. Healthy
real rates seem to remain far off in the future and gold should
continue to thrive even in today's low real-rate environment.
Adam Hamilton, CPA
March 25, 2005
Thoughts, comments, or flames? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!
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