Real Rates and Gold 3
Adam Hamilton November 22, 2002 2988 Words
When my infuriating alarm clock started blaring and eviscerated my blissful sleep at 0230 Tuesday morning, a Herculean struggle ensued. Should I stay in my warm, comfortable bed or drag my sorry carcass outside to watch the much-hyped Leonid meteor storm?
After a few minutes of excruciating procrastination, I stumbled out of bed, donned my trusty Carhartt body armor, and trudged bleary-eyed into the cold night air. The moon was nearly full so bright ambient light obscured the starscape, but since I was already out of bed I figured I may as well search for meteors anyway.
After plunking down in a reclining lawn chair and staring into space for ten minutes, the celestial lightshow began. The tiny rice-sized remnants of the decaying Tempel-Tuttle comet were slamming into Earth’s atmosphere at an astounding velocity of 158,000 miles per hour and burning up in spectacular fiery deaths.
The incredible fireworks streaking through the heavens proved well worth the agony of rolling out of bed at such a miserable hour. From 0240-0400 I counted 229 meteors, or almost 3 per minute. The hordes of meteors blitzing Earth like kamikaze UFOs were certainly the greatest frequency of meteoric activity I have seen in all my stargazing days.
While reclining in the cold I was hoping a giant house-size meteor would get sucked into Earth’s gravity well and split the sky in two with its massive flaming tail, but alas it was not to be! Nevertheless, watching the swarms of small meteors streak through the cosmos was a wonderful experience. I’m glad I was blessed with the opportunity to enjoy the show.
While I was a bit tired Tuesday from the celestial nocturnal vigil that interrupted my beauty sleep, the meteors falling from the sky reminded me of the plummeting real interest rates in the States. In recent weeks something spectacular and noteworthy has transpired that we haven’t witnessed for over two decades.
Real interest rates have plunged negative!
The implications of this rare development are profound and extremely important for investors worldwide. Much of the usual investment wisdom is turned on its ear in negative real rate environments.
Like scanning the skies for meteors, we have been patiently awaiting the disembowelment of real interest rates since shortly after Sir Alan Greenspan began his frantic series of last-ditch rate cuts to vainly attempt to short-circuit the usual wickedly-vicious post-bubble bust process. Like a sign in the heavens, now the long-prophesied negative real rates are finally upon us.
Real interest rates are simply the “risk-free” interest rates less the rate of inflation. While the label of “risk-free” is not technically true because no investment or speculation is ever risk-free, modern financial theory claims that United States Treasury Bills, Notes, and Bonds represent the “risk-free” rate of interest. These interest rates are determined every day in the global marketplace and are also known as nominal interest rates.
The only-widely accepted rate of inflation is unfortunately the Consumer Price Index. The CPI is largely a farce for many reasons. Its custodians intentionally exclude the costs of goods that are rising rapidly, they use mathematical wizardry called “hedonic deflators” to arbitrarily deflate real costs across performance units (like computers’ ever-increasing speeds), and they obscure cost increases in life’s core necessities like housing, food, energy, clothing, and education.
Nevertheless, even though the CPI is a joke run by sycophantic bureaucrats paid to create magically-good numbers for their slippery politician-bosses, it is still the only widely-accepted definition of inflation. Hence we reluctantly use it in our calculations.
By subtracting the annual percentage change in the CPI from the marketplace yield of the “risk-free” 1-Year United States Treasury Bills, we can calculate the real interest rate over a one year period. Real interest rates, if positive, tell the massive bond market that its legions of investors can earn a positive return on their capital even after the ravages of inflation.
Negative real rates, on the other hand, are an unmistakable and unambiguous signal to the bond players that they are going to actually hemorrhage core capital by buying bonds because inflation exceeds the return the markets will grant them.
If you are not familiar with the background on and raw importance of negative real interest rates, you may wish to skim the two previous essays I penned on the subject, “Real Rates and Gold” and “Real Rates and Gold 2”. This background will help spin you up to speed on why countless investors globally have been patiently awaiting this stunning portent’s arrival.
Our first graph this week is updated from those two previous essays and shows why the appearance of negative real rates is such a momentous event. As this three-decade-plus data series reveals, negative real interest rates are something the markets have not had to deal with since the early 1980s!
Anyone remember investing through the turbulent 1970s? The US equity markets went through two massive and brutal bear markets. As discussed in “Century of the Dow” the venerable Dow 30 closed at 995 in February 1966. Over 8 years later in December 1974 the index was trading at the dismal level of 578, having excruciatingly hemorrhaged 42% of its value. Horrifically, another 8 years after the 1974 bear the Dow 30 was still trading at only 777 in August 1982, 22% below its peak of 16 years earlier!
If you think stock investors had it tough during this last epoch of negative real rates, think again. Bond investors generally fared far worse than even their bleeding equity brethren!
The goofy warmongering imperial city-state of Washington, DC that is corrupting our great nation believed then, like now, that it could have both guns and butter by simply printing more paper dollars. The insane and out-of-control politicians, much like today, wanted to fight meaningless foreign wars all the time to make themselves feel important as they embarked on their vain personal power trips and to distract the American people from the real problems in the economy.
Vietnam? Iraq? Who cares? Neither third-world cesspool invaded nor declared war on the United States of America! If the Vietnamese or Iraqi people want to be free, they can start their own internal revolutions. If they don’t have the guts or will, they can die in shackles. Our founding fathers of the United States of America warned us over and over to never ever get entangled in any foreign wars for any reason. One of those brave men in history had more wisdom than every single government employee inside today’s Washington Beltway combined!
The result of pushing our nation to spend far beyond its means through war and welfare? Killer inflation and rapidly upward-spiraling nominal interest rates. As all bond investors know, holding an existing bond yielding a low interest rate is suicidal when interest rates are rising. All existing bonds are sold off as bond traders chase the new higher-yielding bonds. Bond principal was decimated in the 1970s as real rates plunged negative.
High inflation brought on by warmongering and welfare-state government largesse slaughtered both stock and bond investors with equal abandon in the 1970s. As a deluge of fresh fiat currency paper created to “pay” for both guns and butter flooded into the economy, pure financial assets denominated in the fiat paper just couldn’t keep up with actual inflation. The scene was unbelievably ugly and I suspect most investors today who were alive then have forgotten how bad the financial environment really was.
Not surprisingly, the only major asset class that thrived in the big-government era of the 1970s was commodities. Gold, shown on the graph above, launched its most spectacular multi-year mega-bull market of modern times as investors fled to hard assets with real intrinsic value. Gold ultimately exploded to bubble levels even higher than the monthly data on the graph above indicates. Its performance was phenomenal!
In the 1970s the US government saw the gold price rising and tried vainly to fight it by selling the official gold owned by the we the people of the United States of America, as well as strong-arming foreign governments to dump their citizens’ official gold too. It didn’t matter. Even head-bureaucrat Richard Nixon couldn’t stop the gold rise with the full force and fury of the US government. The free-markets utterly crushed all attempts to halt gold’s aggressive march to the heavens.
Today market and financial history is repeating yet again. While the US is not on an official gold standard today, reams of evidence exist that the US government and other governments around the world constantly try to talk-down and control the gold price via sales of official gold reserves. Just like the advent of negative real rates marked the end of the US gold standard in 1971, again today the negative real rates will unleash titanic market forces that all the governments on Earth together can’t even hope to oppose.
With negative real rates now rearing their ugly heads for the first time in two decades, investors now have the clearest signal yet that this fledging gold bull we have witnessed in recent years is the real deal! If history is a valid guide, the negative real rates are sounding the trumpet that the Great Commodities Bull of the 00’s has already begun!
Here is another shot of the same data above, zoomed in to only encompass market history since 1990.
Gold languished during the 1990s as real interest rates were healthy. Bond investors could earn real returns, growing their precious capital by investing in bonds last decade. Also in the 1990s, as everyone today remembers well, US equities were soaring in their greatest bull market ever. Compounding the gains in stocks and bonds, the mighty US dollar’s ascent encouraged foreign investors to buy dollars to jump into the fray and reap the huge profits from the wondrous US financial markets.
It is quite provocative above that the only signs of life gold showed during the whole decade, with the notable exception of the spectacular 1999 Washington Agreement spike on news European central banks would cap their official gold sales, occurred when real interest rates threatened to plunge below zero. Note the sharp 1993 gold rally in the graph above. It erupted the very month that real interest rates hovered right at zero!
Fast forward to early 2001. Our current young gold bull market today first started galloping when real interest rates merely threatened to plunge negative on the madness of the Greenspan Gambit of radical short-term interest-rate manipulation. I don’t think it is a coincidence at all that the new gold bull was born exactly as the black 1-Year T-Bill yield above plunged in response to the Fed’s Communist-style command-and-control economic manipulation of the price of money.
With real interest rates now unambiguously and undisputedly quite negative again, short-term bond investors are getting raped by our guns-and-butter government running the proverbial printing presses to pay for all of its ridiculous expenditures. They are losing their precious capital every year by merely owning short-term bonds! Negative real rates are once again almost certain to only accelerate the growing gold rally.
Zooming in yet again, our final graph this week encompasses only the last few years and actually has daily numbers instead of monthly data. Other than the infuriatingly-deceptive CPI, which is thankfully only available from the government bureaucrats once a month, everything else shown below is daily-closing data. The new negative real rate environment looks even more ominous at this resolution!
Once again it is quite provocative that the entire gold bull market to date coincides with low real interest rates, often under 1%. Even though officially-reported CPI “inflation” has generally miraculously fallen in the last few years, the Greenspan Fed’s frantic attempts to bail out underwater stock speculators has forced nominal 1-Year T-Bill rates under even the watered-down CPI inflation rate.
The relationship between the price of gold and real rates is even more apparent zoomed in to a daily scale. The rock-solid gold uptrend lines are shown above, with the Ancient Metal of Kings still oscillating around its upper resistance line. As anticipated in “GoldTrends 3” gold’s technical midline has indeed held in recent months as new support, great news! It is hard to imagine a more technically-bullish picture for the long-maligned metal than what we are witnessing today.
The central banks and governments issuing fiat-paper currencies, always at war with the timeless and true monetary standard of gold, seem to be fighting for their dear lives at Gold’s $325 Maginot Line. So far they have been able to stem the tide of increased gold investment demand, but gold is coiling ever tighter against this key resistance line.
Even though many gold investors grow pretty forlorn when gold is repelled from $325 under heavy fire, the new negative real rates today change the whole ballgame. Historically negative real interest-rate environments have been one of the ultimate indicators that a massive gold bull market is underway, and today this signal flare has been shot up into the heavens again.
I believe the $325 Maginot Line will fall, with gold surging through to the upside, if the real interest-rate environment remains negative. Since I am a mere mortal I can’t tell you if it will be six days or six months from now, but I have no doubt that it is coming. The Greenspan rape of savers can only increase investment demand for gold, and global supply and demand forces can squash government wishes to contain prices like annoying gadflies.
Gold will not remain shackled under $325 if real rates remain negative!
Will real rates remain negative? Probably. The only two variables that matter for calculating real interest rates are 1-Year T-Bill yields and CPI inflation. What is the highest probability course for each of these important ingredients to the real rates equation in the coming year?
The Communist-Politburo-style command-and-control Fed can’t directly manipulate 1-Year Treasury yields, but it can indirectly bully the short-term bond market by manipulating the overnight Fed Funds interest rate. If Greenspan and his comrades manipulate the fed funds rate higher, they can throw bond investors a bone and help increase real rates. But, as any stock speculator will tell you, if the Fed raises rates in these fragile and dangerous economic times, the still vastly-overvalued US stock markets will plunge like Leonid meteors.
The Fed may be forced to continue the Japanization of the American economy by slashing nominal interest rates to zero, but I don’t think there is much chance at all that the Fed will raise short-term rates and slaughter the already wounded US stock markets. At this peculiar moment in history it looks like the 1y T-Bill rate could be coerced down by a Fed rate cut, but probably won’t be forced up.
On the CPI front, inflation is ultimately a purely monetary phenomenon. If you don’t believe me check any dictionary or economics textbook. When relatively more money chases after relatively fewer goods and services, which is monetary inflation, the expected general price increases are the inevitable result. With more money in circulation each dollar is worth less and less in terms of what it can buy.
Yes, the Washington, DC bureaucrats are the world’s most accomplished liars, but lies will only suppress the CPI so long. With enough monetary expansion it doesn’t matter what numbers they want to show, the truth will eventually surface. As of this week the US money supplies are up incredible absolute amounts in annual terms. The year-over-year M1 growth rate is 4.3%, MZM 8.4%, M2 7.2%, and M3 5.7%!
As the Greenspan Fed merrily inflates away so the politicians can have both their endless foreign wars to distract the American people and a welfare state to bribe their votes, the new dollars flooding into the guns-and-butter economy will inevitably breed inflation that even the CPI wizards can’t hide. Monetary inflation far higher than the CPI’s 2%+ levels will most likely drag the deceptive index even higher.
Will real interest rates remain negative? The Fed can’t manipulate short-term interest rates up without gutting the struggling US stock markets. The CPI bureaucrats will have a harder and harder time hiding monetary inflation as it increases. With the 1y T-Bill rates unlikely to shoot higher and the CPI unlikely to crash lower, the dreaded negative real interest rates are probably going to be around for awhile.
The rules of the investing game are totally different in a negative real interest-rate environment. Stocks do horrible. Bonds do horrible. But hard assets like commodities and gold thrive.
What? You don’t respect gold? Still believe the tired Keynesian government propaganda that it is a “barbarous relic”? It doesn’t matter. Amazingly enough, the global markets don’t even care what you or I think. The enormous supply and demand forces around the world are pushing gold higher whether you believe it’s happening or not.
It is not the markets that must conform to our personal expectations, but we who must recognize the prevailing market reality and conform to it! We can choose to play the game the way the markets demand, or be destroyed.
US stocks are heading far, far lower as the Long Valuation Waves force them down and valuations revert to their mean, totally independent of negative real interest rates. Bond markets are in serious trouble as long-term interest rates trend higher in response to the endless-war guns-and-butter fantasy Washington, DC is perpetrating upon the American people today.
Just like the wondrous meteor storm I dragged myself out of bed to marvel at early Tuesday morning, real interest rates are plunging from the heavens. They are negative already, but history shows they can plummet much, much lower before we emerge safely from the clutches of this horrific supercycle Great Bear bust.
Investors today owe it to themselves to quickly get up to speed on how negative real rate environments could affect their scarce and precious capital, and deploy their assets accordingly.
Adam Hamilton, CPA November 22, 2002 Subscribe at www.zealllc.com/subscribe.htm