 Real
Rates and Gold 7
Adam Hamilton
Archives
May 28, 2004
With gold falling 12% and
the HUI gold-stock index plummeting 29% from early April to mid
May, it has been a tough couple of months for gold investors.
The technical weakness in prices has been very intense at times.
In fact, in April three distinct
and vicious plunges in the HUI so battered various technical
studies based solely on gold-stock prices that some trading models
are predicting the equivalent of gold-stock Armageddon. Prices
plummeted so unbelievably fast that at least one popular speculation
system is suggesting that an unprecedented 90% crash in gold-stock
prices is probable!
As the all-time high in the
HUI of 257 was just achieved early last December, a 90% drop
in this flagship unhedged gold-stock index would yield a bone-shattering
HUI low of 26 or so. How incredibly low is this? Well, in November
2000 when this gold-stock bull first started sneaking northward,
the HUI fell under 36 for a day. So a 90% HUI Armageddon would
pummel this index far below even its all-time Great Bear low
of late 2000. Yikes.
Could such an event really
happen? It sure could. The markets are nothing more than a giant
study in probabilities. As probability theory states, there is
nothing with a probability of one, a certainty of happening,
and nothing with a probability of zero, a certainty of not occurring.
There never have been and never will be any certainties in the
financial markets.
While I believe that a 90%
plunge in gold stocks from here likely has a probability approaching
zero, it is not zero. Even though it is improbable, it is certainly
possible with the right combination of events. As a gold-stock
investor and speculator myself though, I have to admit that I
am not at all worried about such a staggering development. Why?
One of the primary reasons is I perceive an enormous technical
and fundamental disconnect right now.
Technical analysis, the art
of analyzing the markets based on price data alone, does not
operate in a total vacuum. I am a huge fan of technical analysis,
having written hundreds of essays
analyzing prices as well as developed many of my own technical
tools from scratch in order to attempt to execute superior
trades. Yet, technical analysis must be considered within the
strategic fundamental market context.
Technical analysis is tactical,
focusing on making tough real-time trading decisions within short
time frames. Fundamental analysis on the other hand, which compliments
technical studies beautifully, is strategic in nature. Fundamental
analysis focuses on the prevailing long-term trends that are
acting over years and the real-world supply and demand forces
driving them.
One analogy that nicely describes
the interplay of fundamental and technical studies involves driving
a car. When you drive a car, you darned well better be able to
see out the windshield so you can make instant decisions about
when to steer, accelerate, and brake. Your survival depends on
you being able to react to current conditions rapidly and chart
a safe course through countless random risks. Technical analysis
has a similar tactical focus on the immediate.
Yet, even while you concentrate
on driving, you also need a broad strategic plan. You can steer,
accelerate, and brake all you want, but if you donít know
your final destination then the whole exercise is pointless.
The idea of driving is to get you from point A to point B, but
you need to know in advance where you are going. All of the tactical
driving decisions you make in real-time contribute to you ultimately
reaching your destination. Fundamental analysis has a similar
strategic focus on the big picture.
Relying exclusively on tactical
technical analysis without considering strategic fundamentals
is like driving a car with no idea of where you want to end up.
You can be driving along, see an accident, properly and prudently
quickly react tactically to steer around and avoid it, yet still
end up lost in the middle of nowhere. I believe a similar tactical
and strategic disconnect is happening in the gold-stock world.
Gold and gold-stock prices
have indeed been exceptionally weak in recent months and it is
no wonder so many technical trading systems are throwing up all
kinds of red flags. Yet, we need to consider the strategic fundamental
context in which this weakness occurred. While there are many
fundamental factors to consider, one of the most important is
the relationship between the price of gold and real inflation-adjusted
interest rates.
I penned my first Real
Rates and Gold study in July 2001, when gold was still trading
in the $260s near its long-term Great Bear bottom. The central
fundamental thesis of these studies is that the most favorable
monetary environment possible for gold is one where the rate
of inflation exceeds the nominal short-term interest rates. When
real rates are negative, investors actually lose purchasing power
and grow poorer every year simply by holding short-term bonds.
If you are not familiar with
the dire implications of negative real rates for investors and
savers, you may wish to skim my last update of this negative
real rates study, Real
Rates and Gold 6 published in January. Rather than again
walk this well-traveled ground of discussing why negative real
rates naturally lead investors into gold, this week I would like
to use them to offer a bullish fundamental argument that easily
trumps the recent weak technicals.
Regardless of the recent technical
carnage, the price of gold is not likely to head lower in a negative
real rate environment. And gold stocks are nothing more than
leveraged
proxies on the price of gold. If gold is driven higher by
negative-real-rate induced buying, then gold-stock profits will
soar ultimately driving up gold-stock prices. The only way that
a gold-stock Armageddon is even possible is if gold utterly collapses,
and as I think you will agree after studying these graphs this
is a very unlikely proposition.
Both of these charts are the
latest updates of the original July 2001 real rates and gold
graphs. Just as they provided very powerful evidence that a gold
bull was being born three years ago, they are very unambiguous
today in predicting much higher gold prices as more investors
flee the negative real yields of short-term bonds and seek refuge
for their capital in the Ancient Metal of Kings.
Real interest rates are calculated
by subtracting the annual change in the US Consumer Price Index
from the yield on one-year US Treasury Bills. When they are positive,
investors can increase their purchasing power every year by investing
in short-term bonds. This is the natural state of the markets,
where investors are rewarded for accepting risk.
When real rates are forced
negative however, the mere act of investing leaves investors
poorer every year as general prices increase faster than their
invested capital. This is an unnatural and very harmful financial
environment caused by central-bank manipulation of the price
of money, or short-term interest rates. Negative real rates ultimately
spawn huge capital shifts that can dramatically alter the investment
landscape.
As you can see above, the greatest
gold bull markets in modern history occur when real interest
rates are either negative, or threatening to go negative, or
rapidly falling. Gold tends to be the strongest when real rates
of return on debt investments are the weakest. At these peculiar
times in history when deploying capital in short-term debt assures
a real loss of purchasing power, investors flee to gold for refuge
and drive up its price.
Also intriguing from this long
strategic perspective, gold bulls only seem to weaken and end
when real rates shoot massively positive, to at least 3% and
often above 4%. If real rates in the United States were heading
through +3% today, then the fundamental case for gold would be
very bearish. But, with real rates currently still negative for
the first extended period since the 1970s gold superbull, todayís
real rate environment remains supremely bullish for gold.
As you examine the chart above,
pay careful attention to every major downleg in the Ancient Metal
of Kings. You will notice that major persistent gold price weakness
generally does not occur in modern history when real rates are
negative. This fundamental piece of the gold puzzle is very important.
If one was so intensely focused on technicals alone that they
ignored all fundamentals, then they would have no idea that gold
is currently sojourning in the most bullish monetary environment
in decades.
In order for the gold-stock
Armageddon to unfold that some purely technical trading systems
are predicting today, the gold price has to plummet. But, gold
has never entered a major downleg in modern history when real
rates are negative, with the curious exception of the mid-1970s.
But even in that case, gold corrected temporarily only when negative
real rates were skyrocketing higher and striving for positive
territory. There is no similar massive spike up in real rates
today and therefore no monetary catalyst for this gold bull to
fail here.
If gold is not about to plummet,
then there is also no sound argument possible for a massive worldwide
liquidation of profitable unhedged gold producers. Whenever there
is a conflict between short-term technicals and long-term fundamentals,
the powerful supply and demand fundamentals almost always prevail.
There is simply no historical reason to expect our gold bull
to end in the current negative real rate regime that we are suffering
through in the States.
Even if you are willing to
concede the unlikelihood of a gold and gold-stock collapse while
real rates remain negative, the next logical question to ask
is when will real rates again shoot positive and threaten gold?
Our second chart zooms in to the past four years or so to help
us address this crucial question.
This shorter-term chart really
illuminates a lot of important insights on both our current gold
bull and the interplay between inflation and T-Bill yields that
has driven real rates negative for the first time since the 1970s.
If real rates are to soar higher and threaten the gold bull and
slaughter gold stocks like lambs, then there are only two possible
ways for this to happen. Either the Fed raises nominal rates
massively or inflation in the US plummets to zero.
The blue and red real rates
line, as mentioned above, is calculated by subtracting the white
annual-change-in-the-CPI inflation line from the black one-year-Treasury-Bill-yield
line. In order to force real rates to rocket positive and threaten
the gold bull, the Fed could dramatically raise the price of
money by jacking up short-term interest rates, the black line,
like there was no tomorrow. Is such a scenario likely?
Even if you happen to be one
of the many folks who believe that the Fed somehow mystically
controls the US financial markets like the Wizard of Oz, you
have to admit that a huge surge in real rates is extremely unlikely.
Actually short-term rates are the only thing the Fed really does
directly control, and if it wanted to it could probably force
rates higher in a short period of time to help end the negative
real rate madness. But, due to the huge magnitude of the rate
hikes required to pull this off, such a course of action would
not only hurt gold but decimate stocks, bonds, and residential
real estate. It may even spawn another Depression.
Recall from above that real
rates in the +3% to +4% range are generally needed to entice
capital back out of gold and into bonds in a big way. And not
only do real rates have to go this high, in order to be enticed
to act investors must be convinced that the Fed intends to keep
nominal rates high for a long enough period of time to maintain
massively positive real rates. Assuming that inflation remains
constant at the low 2% to 3% range, the Fed would have to ratchet
up short rates enough to push one-year Treasury yields to the
5% to 7% range to hit 3% to 4% real!
With the overnight fed funds
rate that the Fed directly controls now hovering at the unnaturally
low level of 1% today, we would probably need the FOMC to issue
a kamikaze series of rates hikes in rapid succession until this
overnight rate exceeded 4%. Anything less and it is unlikely
that one-year T-Bill yields would trade high enough to bring
back massively positive real rates and end the merciless attack
on investorsí capital.
Now if overnight rates soar
from 1% to 4%, can you imagine what this would do to the stock
markets, the bond markets, residential real estate, and the US
economy? Talk about financial Armageddon, this might be it! This
magnitude of a Fed move from such unnaturally low rates would
quadruple the overnight price of money and probably double or
triple the costs of borrowing for the average business or consumer.
Even if it only doubles interest payments, the impact over our
entire debt-laden economy of twice as much cash heading into
debt service would be staggering.
Stock prices would plummet,
perhaps even crash if the quadrupling of rates was fast enough.
Overall corporate profits would decline precipitously as todayís
thin profit margins in such a competitive global landscape were
further squeezed with higher interest payments. In addition to
absolute profits falling, all the Wall Street folks who still
believe in the discredited interest-rate
stock valuation models would be forced to lower their acceptable
P/E ratios for the general markets.
And while things would certainly
look ugly in stocks, bond investors holding existing lower-yielding
bonds would be eviscerated by a quadrupling of the short rates.
As interest rates go up, existing bonds are sold off until they
have lost enough face value to effectively yield the new higher
market rates. While this is great for bond investors buying new
bonds, investors holding existing bonds would watch in horror
as their principal furiously eroded.
And in residential real estate,
todayís whole mania in housing prices is totally dependent
on the notion that home costs can rise forever as long as new
buyers can borrow the huge sums necessary at cheap interest rates.
As unnaturally low interest rates are the linchpin holding the
fragile spiraling housing market together, if the Fed quadruples
short rates this game is over. As mortgage costs doubled, the
amount of debt Americans could carry would plunge and housing
prices would crash.
Thus, regardless of how little
the Fed happens to like gold, the costs of quadrupling short
rates to bring real rates massively positive are staggering and
far too high. No rational bureaucrat who values his future would
risk crushing stock, bond, and real estate investors simultaneously
just to end a gold bull. While nominal rates will rise gradually,
negative real rates are likely to persist for a long time to
come yet and are very bullish for gold. The black 1y T-Bill line
above is not likely to skyrocket to 5% to 7% anytime soon.
The only other alternative
to spawn positive real rates of 3% to 4% is for inflation in
the US to plunge. The white YoY CPI line above would have to
magically journey below zero, however, in order to see real rates
even approach positive 3%. What are the odds of US inflation
plunging to nothing? Probably as close to zero as one can get
in the financial markets!
Since 1971 when the US dollar
gold standard was terminated by the Nixon regime, money
supplies in the States have been relentlessly ballooning.
Inflation is caused by relatively more money chasing after relatively
fewer goods and services. In order for inflation to fall moderately,
let alone fall to nothing, the Federal Reserve would have to
quit creating new money for years in order to sop up the current
huge excesses of fiat dollars. Such an event has never happened
before.
In just the past year alone,
the Fed has grown MZM money by 5.1% and broad M3 money by 5.6%,
the true US inflation rates. These new dollars, as always in
history, eventually start bidding up prices in the US economy.
The reason that everything from homes to cars to food costs much
more than a decade or two ago is because of fiat-currency inflation.
The Fed could conceivably stop adding money to our system, but
it isnít going to happen. Debt-based fiat-currency regimes
like our current example in the US must either expand perpetually
or fail catastrophically. History is very unambiguous on this.
So, our current negative real
rate environment, which is so bullish for gold, has been spawned
by the Fed. At the very same time it continues to pump new dollars
into the US economy which bid up prices, it has forced interest
rates to unnatural nearly half-century lows in a foolish attempt
to bail out the bubble stock-market speculators of the late 1990s.
To now mess dramatically with either the low rates or monetary
growth could certainly spark a systemic crash of epic proportions.
If the Fed cannot raise nominal
rates high enough fast enough to push real rates positive, and
if it cannot quit creating money to eliminate inflation, then
real rates in the US are going to remain negative for some time
to come. And there is no more bullish monetary environment for
gold and hence gold stocks then these rare negative real rate
episodes. Note on this chart how our current gold bull didnít
start until real rates threatened to plunge negative for the
first time in decades.
Coming full circle, the technical
prophecies of gold-stock doom are focusing on price alone, as
all pure technical analysis does. But, the problem is technical
analysis done in a total fundamental vacuum can be really misleading.
Extremely positive supply and demand fundamentals can trump ugly
technicals any day.
Gold stocks ultimately depend
solely on the price of gold. As gold goes higher so do their
profits
and eventually their stock
prices. In order for gold stocks to fall off the face of
the earth as some technical studies suggest, the gold bull itself
has to fail. But gold bulls generally do not end until real interest
rates shoot massively positive. But in order to make real rates
massively positive to lure capital back out of gold, the Fed
would have to slaughter stocks, bonds, real estate, and probably
the US economy simultaneously. Highly unlikely to say the least.
Technical analysis is highly
valuable and tremendously useful. But it needs to be viewed within
the overarching strategic fundamental context of the markets.
Using technical analysis exclusively without considering the
background supply and demand context is like driving with no
destination in mind. The probability of getting lost and missing
fantastic opportunities is quite high.
Our acclaimed monthly newsletter,
Zeal
Intelligence, attempts to integrate cutting-edge technical
analysis with battle-tested fundamental analysis in order to
maintain the crucial strategic perspective while we strive to
execute tactically superb gold-stock trades. Please join
us today to learn how to profit from this awesome ongoing
gold bull!
The bottom line on this latest
negative real rates update is that the powerful bull market in
gold is almost certainly not over yet with real rates likely
to remain negative for a long time to come. Periodic sharp corrections
in bull markets are healthy and expected, and that is exactly
what we have just witnessed in gold stocks.
Please beware of technical
analysis operating in a total fundamental vacuum, taking it with
a grain of salt and keeping the whole strategic picture in focus.
May 28, 2004
Adam Hamilton, CPA
email:
zelotes@zealllc.com
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