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September 07, 2007

Real Rates and Gold 9
by Adam Hamilton

Back in the young days of this gold bull, early 2001, gold languished in the $260s following a multi-decade bear. With little encouraging price behavior at that time, early contrarians focused on supply-and-demand fundamentals to undergird their highly controversial bullish views on gold. One key bullish thesis from those dark early days regarded gold's behavior relative to real interest rates.

Real interest rates are the actual returns realized by debt investors after inflation is subtracted out. So if an investor buys a US Treasury Bill that pays 4% a year, and inflation is running 3% a year, then he is earning a real rate of return of 1% on his investment. His purchasing power, the goods and services his capital can actually buy in the real world, grows by just 1% annually.

Obviously the higher the real rates of return available in the debt markets, the greater the incentive for savers to divert their surplus capital into debt investments (bonds) rather than equity investments (stocks). Bonds are generally vastly less risky than stocks so they become highly attractive to elite investors in high real-rate environments.

But this relationship works the other way too. When real rates of return become too low or even fall negative, savers' incentives to invest in bonds evaporates. If the real purchasing power of your savings isn't growing, then it is time to find an alternative investment where it will grow. With general stocks in a bear market in the early 2000s, contrarians figured that low real rates would drive investors into gold.

And we were proven right of course! Back when I wrote my first essay in this series, July 2001, real rates of return in the US were very low but had not yet gone negative. Gold was trading in the $260s and hadn't even approached $300 yet for the first time in its young bull. But the low and falling real rates of return were stinging bond investors and starting to spark interest in alternative investments like gold.

Between mid-2001 and spring 2005, real rates of return generally stayed negative in the States. Gold powered higher in its biggest bull run in decades, running up over 75% from $255 to $455. I last looked at real rates and gold in an essay in March 2005. By that time they were going positive again but the gold bull had taken on a life of its own and no longer needed low real rates to drive investment in it.

Then just last week an old friend wrote me about real rates and I was intrigued. I haven't thought much about this thread of research for years now. So I decided to break out my dusty old spreadsheets, get some new data, and see what's been happening in this fascinating realm. Given the countless discussions about the Fed and rate cuts lately, it is certainly an excellent time to again consider real rates.

Real rates are the nominal interest rates quoted in the markets less the rate of inflation over the same period of time. Since everyone thinks of interest rates in annual terms, it is best to use simple annual metrics to compute real rates. One-year interest rates are logical and easy to understand, they don't have to be annualized. Comparing a 30-year bond yield to an annualized 1-month change in inflation is an apples-to-oranges type of error.

The ideal nominal interest rate to use is the yield on 1-year US Treasury Bills. Sovereign US debt is considered the most risk-free debt in the investment world. Since the Fed can create US dollars out of thin air at will, nothing short of revolution or invasion will stop the US Treasury from repaying its obligations. While 1y T-Bills aren't widely traded today, the Fed maintains a constant-maturity data series of 1y T-Bill yields which is perfect for real-rate calculations.

On the inflation side of this calculation, the most widely accepted inflation gauge is the Consumer Price Index. Since we are using one-year nominal interest rates, we need to use the annual change in the CPI as our inflation gauge. So real rates of return in the US are defined by the constant-maturity yield on 1y T-Bills minus the year-over-year change in the CPI. Nominal rates minus inflation equals real rates.

Now before you pick up the rotten tomatoes, realize I loathe the CPI. It is a joke. It is heavily hedonized, manipulated, and lowballed for political reasons. Real inflation rates, which are technically the growth rates in the US money supplies, far exceed the sanitized CPI releases. Yet I use the CPI anyway because it is widely accepted by mainstreamers. Using the CPI rather than true monetary growth rates understates the case here and makes it more easily palatable by investors who haven't yet studied inflation in depth.

These charts show the 1y T-Bill yield in black and the year-over-year CPI change in white. Subtracting the latter from the former results in the blue line showing the historical annual real rates of return in the US. Gold, in red, is superimposed over this interest-rate and inflation data. In this initial long-term chart, the real gold price is also used. Nominal gold is adjusted by the CPI to render the metal in today's dollars for superior comparability across decades. There are many interesting things to ponder here in order to establish a crucial historical perspective.

First, in recent history note that real rates in the US first approached zero in 2001. I don't think it is coincidental at all that this gold bull launched off a multi-decade secular low around the same time. Low or negative real rates mean bond investors either can't grow their capital or actually lose purchasing power due to inflation even after their investments. Such a capital-hostile environment leads savers to seek alternative investments including gold.

But since the next chart zooms into the modern period since 2000, we should focus on the long-term aspects of this first chart to establish perspective. For example, note that the black 1y T-Bill yield line declined on balance from the late 1970s to the early 2000s. Although few investors know it today, interest rates move in great cycles just like the stock markets. Nominal interest rates can't go much lower than 1%, so odds are we've seen the secular bottom and interest rates will rise for a decade or more to come.

This has huge implications for debtors. With interest rates highly likely to be in the up-cycle of their long wave now, they should continue to rise on balance. Debtors ought to realize this and insist on fixed rates for their borrowing. As a student of the markets, I was really flabbergasted in 2003 when mortgage brokers and debtors alike were pretending that 1% nominal rates of return, half-century lows, were normal and sustainable. When anything is at a half-century low, including the price of money, odds are very high it will rise for some time to come. The markets abhor extremes.

The white annual CPI inflation line has also been gradually grinding lower on balance since the early 1980s. Even with the heavy political manipulating of the CPI, I suspect that it too has started to travel higher on balance. Since 1983, after the big dislocations of the early 1980s, the CPI has averaged an annual growth rate of 3.1%. Anything much below that, including this past year, is likely an unsustainable anomaly. As is apparent above, sub-2% CPI episodes are pretty rare in modern history.

The blue real-rate line was last heavily negative in the 1970s. While both nominal rates of return and inflation were high, nominal rates still couldn't keep pace with the spiraling inflation as the Fed promiscuously ramped the US money supplies. Note that gold soared in the 1970s. When real rates of return head to zero or lower, owning bonds is a losing proposition that erodes the capital of savers. Rather than subsidize wanton debtors, savers redeploy their capital elsewhere including into gold.

The nearly decade-long negative-real-rates episode in the 1970s is important to ponder. Note that rates initially went negative for a short time and recovered, kind of like today. But inflationary cycles take far more time to unfold so real rates eventually went negative again and helped propel the monster gold bull of that decade. Negative-real-rates episodes in history tend to last for many years on balance, not just short periods of time.

After the 1970s, real rates stayed pretty healthy until the early 1990s. It is interesting that as real rates again approached zero in 1993, gold caught a bid. But soon nominal T-Bill yields shot higher again, pushing real rates way up, and the wind quickly fled from the sails of the young gold rally. Gold then continued declining on balance into the late 1990s as real rates remained healthy.

So interest rates are cyclical and are likely now in a new long-term bull cycle. Inflation tends to rise with, and even outpace, the growth in nominal interest rates in these up cycles. Gold and alternative investments thrive during these times when negative real rates punish rather than reward bond investors for their act of loaning capital. It is no coincidence that the last long low-to-negative real-rate episode was in the 1970s when gold rocketed higher. And today's low-real-rate episode hasn't proved much different yet.

Here is a closer look at the first negative real-rate environment seen since the 1970s, a rare and very important event. Real rates were negative for all of 2003 and 2004 and some of 2002 and 2005. And indeed, despite rising nominal yields on debt, gold commenced its first secular bull market since the 1970s. Poor real returns in the debt markets drive big interest in investing in gold.

The unnatural nominal interest-rate lows of 2002 to 2004 really stand out sharply in this chart. While even the lowballed CPI inflation was running near 2%, 1y T-Bills were yielding just over 1%. So anyone who invested in short-term Treasuries and other debt lost purchasing power for their investment! They actually emerged poorer after investing than before it. Investors won't tolerate this for long and they fled, some into gold and commodities.

Then in 2004 nominal yields started trending higher again but the CPI followed right along so real rates stayed low or negative until mid-2006. Then, while nominal market-generated yields remained flat at a much more reasonable 5%, the annual change in the CPI plummeted. This is highly suspicious based on the index's own history. Odds are the perpetual methodology changes made by the CPI custodians to appease their political masters led to this sudden fall, not slowing underlying inflation in America.

Based on this sudden CPI change, real rates shot up above 3% last year, but they have since fallen to just above 2% as the YoY CPI change continues to rise back up to more normal levels. As a lifelong saver and investor myself, I think even 2% real is totally unacceptable. In the 1980s real rates averaged 4.2%. This is much more reasonable. A saver should be able to earn a fair real return on the fruits of his hard labors, and 2% a year really isn't fair. So savers responded in recent years by buying gold, the ultimate asset to own during inflationary times.

If you look at today on the far right of this chart, the recent sharp decline in 1y T-Bill yields is readily apparent. Due to all the mortgage and credit-market problems right now, capital has been fleeing risky mortgage-related debt and buying high-quality debt including US Treasuries. This huge surge in capital seeking Treasuries has driven down the yields the markets demand that the US Treasury pay for borrowing money. With demand for US government debt soaring, Treasury prices rise forcing the prevailing yields to fall. Simple supply and demand here.

While the nominal rates are falling fast, CPI data lags a month. So this chart reflects the latest available CPI data which isn't yet current to the end of August like the real-time T-Bill-yield data. So far this year, the monthly CPI releases have shown average year-over-year changes of 2.5%. So I think 2.5% is a conservative estimate for the upcoming August CPI data. With nominal rates near 4.0% and the CPI likely to come in at 2.5%, all of a sudden real rates are back down to 1.5% even based on the lowballed CPI.

Under 1.5% real, debt investors get antsy fast. Back in early 2001 when real rates first fell under 1.5% was when gold bottomed and started clawing higher. From the time when real rates fell under 1.5% to the time they went back over 1.5% in 2006, gold powered 181% higher. Although many other fundamental factors besides real interest rates fueled this young bull, the low real rates certainly helped beleaguered debt investors get interested in gold. With real rates once again on the verge of falling under 1.5% for only the second time since 2000, gold is very likely starting its next multi-year run higher.

Now unfortunately we can't discuss interest rates without discussing the Fed. Unlike the sycophantic Fed worshippers on Wall Street, I never mince words on the Federal Reserve. The Fed is an abomination, an engine of devastating fiat-paper inflation born unconstitutionally nearly a century ago. The inflation unleashed by the Fed has done more damage to Americans and the world than any other economic factor. Endless inflation destroys incentives to work and save while gradually eroding the moral fabric of a nation.

The Fed creates paper money out of thin air every day. These new dollars, mostly electronic but also some physical, immediately enter the real economy and start to compete with existing dollars to bid on scarce goods and services. With relatively more money bidding on relatively fewer goods and services, prices for these goods and services rise. A dollar you save today will purchase less and less in the future thanks to the Federal Reserve perpetually ramping the US money supplies.

The Fed also attempts to set the price of money, interest rates. The very act of attempting to set any price in secret by committee is inherently radically anti-free-market. The Fed decreeing the benchmark US interest rates is no different or less ridiculous than the Communist Politburo of last century's Russia attempting to set the price of shoes or milk. Flawed dictatorial pricing decisions made by humans always lead to horrible inefficiencies since they impede natural free-market pricing signals to producers and consumers.

Thus it is sadly entertaining to watch Wall Streeters praise the Fed endlessly on CNBC and Bloomberg. We have a horrible institution centrally-planning our money supplies and interest rates in a perfectly Communist command-and-control form. Rather than denounce it as an abomination that should be slaughtered, Wall Street acts as if central planning is totally rational and normal. What a bunch of hypocrites! Any self-proclaimed free-market capitalist who wants the Fed to exist is a fraud.

Anyway, it now being clear that I wouldn't spit on the Fed if it was burning to death, this institution is in a very dangerous place today. While the Fed likes to believe it sets interest rates, in reality it usually closely follows what is already happening in the short-term debt markets. When market forces drive short-term Treasury yields lower on their own accord, the Fed is generally forced to follow by lowering its own rates.

The Fed can only directly set the rate banks charge each other to borrow overnight (federal funds rate) and the rate it charges banks to borrow directly from it (discount rate). Beyond these overnight rates, free-market forces dwarf the Fed's attempted manipulations. So the Fed sees this chart, sees Treasury rates collapsing due to the flight to quality, and it has little choice but to cut rates or risk capital imbalances spiraling out of control.

On top of the debt markets virtually forcing the Fed to play catch-up by cutting rates, the US stock markets have rate cuts already priced in. Since everyone on Wall Street expects the Fed to cut rates, if it doesn't there will likely be a sizeable selloff or even a mini-panic. The Fed doesn't want to be seen as ignoring the stock markets, so it really needs to cut rates to live up to this ubiquitous Wall Street expectation today.

But while falling Treasury yields and Wall Street demands are forcing the Fed's hand, the US dollar is in a very precarious place technically. The US Dollar Index is on the verge of falling to new all-time lows. Any rate cut will weaken the dollar as international investors move their capital elsewhere to other first-world countries with higher yields. So does the Fed try to preserve the dollar's stability, one of its key mandates, or does it cut to follow the debt markets and then watch the dollar potentially fall off a cliff?

Always a slave to the debt markets and Wall Street expectations, I expect the Fed will cave in and cut rates. Wall Street will love it, but this news is already baked in so the rally will likely be modest. International debt investors will see the Fed as panicking and they will continue their mass exodus out of the dollar, driving it to its lowest levels ever. New dollar lows will beget even more selling and gold will be a prime beneficiary.

And back to our discussion at hand, the Fed lowering rates will reinforce bond-market perceptions of hostile Fed intent to savers and lead to lower yields on short-term US Treasuries. Thus any Fed cutting action, just as in the early 2000s, will drive real rates lower and eventually negative. So it looks like we are now on the verge of another very low or negative real-rate episode in the US. Of course this will be very bullish for gold.

On the Fed, I almost fell out of my chair Tuesday morning. CNBC had a headline "Should Fed Be Abolished?" running across the bottom of its screen! I unmuted the TV and was amazed to see an interview with four people discussing this very question. Of course 3 of the 4 were closet Communists and pro-Fed, but there was a lone free-market guy there. In 2000 when Greenspan was worshipped as a demigod, even such talk on CNBC would have been unthinkable. So maybe we are finally moving in the right direction in popular discourse.

With real rates falling to low levels and probably heading negative again, gold should thrive in the months and years ahead. Low real rates are but one of many very bullish factors for the yellow metal. If you want to ride this ongoing secular gold bull that low real rates will continue to help drive, the best leverage available is obtainable in high-potential PM stocks.

Thus at Zeal we continue to layer in positions in elite precious-metals miners and explorers. We are constantly doing extensive fundamental research to uncover the most promising commodities stocks. And when opportune technical times arrive, such as the silly mini-panic in PM stocks in August, we aggressively add new positions. Subscribe today to our acclaimed monthly newsletter to multiply your capital through this awesome gold bull!

The bottom line is prevailing US rates of return after inflation are low today and will probably go negative again soon. During such episodes in history, gold tends to really thrive. Debt investors, tired of trivial gains or actual losses of purchasing power in return for lending their capital, join in the gold rush to preserve their capital through financial-market conditions openly hostile to savers.

The Fed, which shouldn't even exist, is in a tough position today. It has to cut rates to follow the debt markets' lead and appease the stock markets. But a rate cut will likely push the dollar over the edge to new all-time lows which will drive even more capital into gold. So while the Fed now faces a lose-lose situation, gold faces a win-win situation today.

Adam Hamilton, CPA
Zeal LLC.com

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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