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March 25, 2005

Real Rates and Gold 8
by Adam Hamilton

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
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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