Real Rates and Gold 4
Adam Hamilton April 4, 2003 3029 Words
What a phenomenally fascinating time to be a contrarian investor and speculator!
With the major financial markets totally fixated on the war, emotions reign supreme and logic and reason have been unceremoniously thrown out the window. While the investing masses frantically trade on the endless confusion of ultra-short-term tidings from the front, patient contrarians are being blessed with amazing opportunities.
Probably the single greatest long-side opportunity that the bewildering fog of war has granted to us contrarians has arisen in the gold world. The popular Wall Street party line today claims that gold is dead since the entire gold rally was merely a temporary “flight to safety” play over the impending Iraq war. Now that the war has started, Wall Street boldly asserts that the reasons to own gold have evaporated.
Now for those whose idea of long-term market research is watching CNBC for 10 minutes at lunch, maybe the Wall Street assumption on gold makes sense. For patient contrarians who understand what really drives markets over the long-term, however, the Iraq war gold-sell-off theory leaves much to be desired.
Provocatively the bull market in gold launched two years ago, well before the heated debate running up to the Iraq war and even before the 9/11 terrorist attacks in the United States. If gold had only been rising for a few months the Iraq war thesis would probably have some merit, but with gold galloping higher for a couple years now the Iraq war obviously hasn’t been the prime driver of the entire new gold bull.
I am painfully well aware that investors and speculators today are consumed by their own fleeting emotions and are hanging on every shred of fresh news from the front, but ever the financial heretic I would like to step back this week and review the current gold-market scene within its proper long-term strategic context.
Today one of the most powerful gold buy signals in history is strongly suggesting that the great gold bull is just getting started, regardless of the progress in the Iraq campaign. This signal is negative real interest rates, a frightening financial force of such exceeding danger to capital preservation that it makes weapons of mass destruction look like firecrackers.
I last wrote about negative real rates in my “Real Rates and Gold 3” essay over four months ago around Thanksgiving. Our graphs this week are updated from this earlier essay, which you may wish to skim if you would like more background information on the graphs themselves or negative real rates in general.
Interestingly, the emotional backdrop in the gold market last November was very similar to today’s. Gold investors and speculators were unbelievably forlorn and negative because gold had been trading sideways for over five months and its long-oppressive $325 Maginot Line resistance was holding solid. During this depressing period gold had even carved a series of slightly lower highs, leading some folks to lament and believe that the gold bull was over.
Back then, just as today and always, the majority of investors and speculators were hypnotized by the short-term. They fell into the ancient financial trap of short-term linear extrapolation to falsely assume that a short period of trading would extend into infinity in the future. The immense distractions of war today are creating the same phenomenon, with countless folks betting everything that the brief two weeks of trading activity during the early Iraq war will extend indefinitely out into the unknown future.
As always though, in November 2002 there were lots of clues for patient contrarians to uncover suggesting that the gold bull was ready to break through its $325 resistance and march to new highs. The massively powerful negative-real-rates gold-buy signal captured my own attention as a contrarian, leading me to write at the time, “Gold will not remain shackled under $325 if real rates remain negative!”
Since those dark days in November, gold has exploded up to dazzling new heights in its bull market to date, delighting gold investors. Then the Ancient Metal of Kings fell hard, exhibiting a major pullback that soon sucked the wind right out of the sails of many gold investors. Now gold is once again struggling along near its long-term support and gold-investor morale is quite low.
There is hope though fellow gold investors and speculators! The same long-term real-interest-rates graph that led us safely through the short-term gold apathy and fear of last November to the glories of the awesome recent gold upleg is even more bullish today! Feast your eyes upon this!
This stunning strategic chart, one of my all-time personal favorites, compares the monthly price of gold over the last three decades or so with the real interest-rate environment. As even an investor from the legions of the newly-minted stock-market insta-bulls would have to admit, gold shines whenever real interest rates approach zero or plunge negative.
Real interest rates are an extremely important economic concept. They are calculated by subtracting the rate of inflation from the “risk-free” nominal interest rate over the same slice of time. Even though it is perpetually understated and manipulated for political reasons, we use the conservative actual one-year percentage changes in the US Consumer Price Index to calculate our inflation rate to find the real rate.
A nominal interest rate is merely the actual quoted interest rate that you can earn in the markets at any given moment in time. To graph nominal rates, we use the most conservative possible nominal interest rate, the rate of return on 1-Year United States Treasury Bills. These US federal government debt obligations are widely considered to be “risk-free” since the US government can both print paper dollars at will and also extract capital via gunpoint from bleeding American taxpayers.
When the year-over-year change in the CPI is subtracted from the yield on 1-Year US T-Bills, the real interest rate is the result. Real interest rates are so important because they show exactly what a saver would earn in terms of true purchasing power if he or she held money-market-fund cash for one year. Real interest rates are immensely influential on the ultimate behavior of savers, for good reason.
Contrary to the popular bullish sentiment running rampant today in equities, it is not the fear of Saddam Hussein’s weapons of mass destruction that ultimately drives the US economy, but savings. No jobs can be created, no new companies can be launched, and no new projects can be undertaken without saved capital. Every private enterprise in existence in the world today was initially created out of someone’s hard-earned savings, either the original entrepreneurs’ themselves or other people’s savings borrowed in the capital markets.
Sadly, those who choose to make the sacrifice to save some of the hard-earned fruits of their labors are growing scarcer in America today. Current macroeconomic statistics are unambiguous in revealing the depressing state of reality that most Americans have willingly chosen to be debtors. Unfathomable amounts of personal debt are willingly taken on by Americans in order to finance the purchase of depreciating assets, consumables that will never increase the capital of those who buy them.
While the vicious downward spiral into debt eventually leads to ruin, the path to prosperity is paved by saving. Only by consuming less than one earns is it possible to build up capital reserves and become an investor and speculator. The only road to wealth is through saving! The savings of savers ultimately undergird the whole US economy as they are transferred from savers to entrepreneurs via the equity and debt markets.
Not surprisingly, those willing to sacrifice their current consumption and standard of living to save and accumulate future wealth are very concerned about the preservation of their savings. It takes an unbelievable amount of hard work, blood, sweat, and tears to build a fortune and the last thing a saver wants to happen is to see their saved labors destroyed.
The most subtle yet damaging enemy of savers and their painstakingly saved capital is inflation. Inflation is caused by governments irresponsibly running their paper-money printing presses and producing fresh currency faster than the underlying supply of goods and services on which to spend it is growing. As more brand new fiat currency is created out of nothing, all the existing currency is worth less and less in terms of what it can really buy.
Now a saver doesn’t work hard to save a dollar today in order to watch its value be decimated by inflation tomorrow. A saver wants and needs to ensure that a dollar put aside today still has similar or greater raw purchasing power tomorrow. It is for this reason that savers are rightfully incredibly sensitive to real interest rates.
When real interest rates are positive, as is normal and healthy, savers can place cash in savings or money-market accounts and be sure that the surplus fruits of their hard labors can grow faster than the general prices of goods and services. They earn a fair return on their savings.
Savers like normal positive real interest-rate environments because they know that their savings are relatively secure and modestly growing in cash-type investments and they can pick and choose whether they want to redeploy some capital into far riskier arenas like bonds and stocks at their own leisure.
Negative real-rate environments, on the other hand, create huge problems for the savers who ultimately drive the entire US economy. As of the latest available CPI figures, February, watered-down official inflation in the US was running 3%. Since MZM money has grown by almost 8% over the past year in a private-sector US economy that is shrinking (fewer goods and services on which to spend the increasing money supply), actual inflation rates outside of government statistical tyranny are probably more than double the official rates.
At the same time that official lowballed inflation is running 3%, savers can only earn a little over 1% in “risk-free” short-term US government bonds. Since savers can only earn 1% in cash-type investments while general price levels are increasing by at least 3%, savers are losing at least 2% in purchasing power every year. Negative real rates are a direct punitive and immoral stealth tax on savers levied by government via its printing presses!
Now if you are a saver today, zealously consuming less than you earn so you can build a better future for your family and your nation, you are faced with some very difficult choices.
If you leave your capital in money-market funds, you are guaranteed to lose at least 2% in purchasing power in the coming year. If you follow Alan Greenspan’s badgering to get back into today’s vastly overvalued stocks, you will fully expose yourself to the worst bear market since the Great Depression and almost certainly lose in the end. If you buy into the bond markets today you risk getting gutted like a fish by war inflation and rising general interest rates, which cannot and will not stay at 45-year lows forever and will eviscerate bonds when they inevitably begin to march higher again.
Needless to say, all of these choices are absolutely unacceptable since they are all highly likely to lead to serious losses. Negative real interest rates paint savers into a corner where capital preservation, let alone capital growth, becomes extremely challenging. The ultimate answer to these rare situations of negative real rates is gold, which will always rise more than enough to offset government inflation and preserve purchasing power over the long-term.
Negative real interest rates literally force savers into gold since it is the most liquid and safest fortress into which their capital can be parked and protected through the ravages of inflation running higher than nominal interest rates. The long-term graph above clearly shows this phenomenon of savers flooding into gold in history during these ugly negative-real-rates episodes.
In the 1970s real interest rates stayed negative for most of the decade as inflation outpaced nominal rates of return for savers. Naturally they flooded into gold to take refuge, unleashing a magnificent gold bull market and ultimately even driving the Ancient Metal of Kings into its own bubble mania that wasn’t too different psychologically from the NASDAQ 2000 bubble.
Similarly, in the last couple decades gold rallied dramatically whenever real interest rates dropped significantly, approached zero, or even plunged negative as today. Conversely, when real interest rates were stable and healthy gold tended to fall as savers were quite comfortable in cash-type investments and saw no need to flood into gold.
Yet today real interest rates are once again massively negative as Alan Greenspan has chosen to artificially manipulate short-term interest rates far too low in order to vainly try and reignite the late 1990s equity mania. These artificially low short-rate environments have caught savers in the crossfire and helped accelerate a new bull market in gold.
Our next graph zooms in on this epic battle between savers and low/negative real rates, adding daily data (except for the monthly only CPI) so we can watch the anti-saver campaign unfold at a higher resolution.
It is quite provocative that the two-year-old gold bull didn’t start until real interest rates fell below 1% as the US Fed decided to subvert free capital markets and chose the brazen manipulation of short rates to try and foolishly reinflate a doomed equity bubble.
For the first year and a half of the gold bull, savers slowly moved into gold as real interest rates fluctuated between nothing and 1% or so. Even though the Fed was slashing short-term rates like there was no tomorrow, effectively robbing prudent savers to bail out irresponsible debtors, the official CPI inflation rate somehow managed to come in incredibly low, ensuring that real rates didn’t plunge decisively negative for the first time in decades.
By mid-2002, however, nominal 1-year Treasury yields continued to grind lower while officially reported CPI inflation began to rise back up towards its 3.3% average since 1982. Real interest rates plunged massively negative for the first time since the inflationary mess and gold bonanza of the 1970s. The advent of negative real rates once again is an ominous tiding that betrays tough times ahead for capital in intangible paper that can be easily ravaged by government inflation.
Savers have been put on notice and warned by the Fed. Even though they ultimately drive the US economy by saving the capital necessary to fund the entrepreneurs that create and grow businesses to employ Americans, the US Fed announced a declaration of war on savers when it decided to manipulate short rates down under the rate of inflation.
Not surprisingly, the financially savvy savers did exactly what they needed to do to counter this growing US threat against the saved surplus fruits of their hard labors. They accelerated their buying of physical gold which led to a dramatic gold upleg commencing in December 2002 as real interest rates continued to plunge farther into the red. Savers, especially foreign ones, also sold the US dollar hard as they wisely chose to flee the fearsome juggernaut of US monetary inflation.
Wall Street’s claim today that the gold bull was merely a rally in anticipation of the war in Iraq looks pretty silly in light of the evidence. The Fed began drastically manipulating short rates lower in early 2001 and savers took notice immediately as the real rates plunged from a fair 3% to an unfair and immoral 1%. Soon after real rates were brutalized, the gold bull began marching higher in earnest and has continued to accelerate ever since.
Now today we find ourselves in an incredibly emotional situation where gold investors are discouraged after a normal healthy bull-market pullback and disinformation surrounding the gold bull is everywhere. Yet, when we slice away the war hype and propaganda, we are left with an ugly environment where real rates are severely negative and savers are left with no refuge but gold in which to hide from the increasing government inflation.
Stocks are still ridiculously fundamentally overvalued even three years into this brutal Great Bear bust, the bond markets will be eviscerated once interest rates inevitably start to rise back towards historical norms again, and real rates are the most negative they have been since the summer of 1980. So what’s a saver to do? Buy gold of course!
The stock markets are not going to be undervalued again any time soon and the Fed won’t be able to raise short rates to fix the negative-real-rate mess since that will slaughter the average heavily indebted US consumer who can barely even afford debt service at current amazingly low interest rates. In addition, gold is once again back down near its 200-day moving average, the fabled point from which it has launched the earlier major uplegs in this bull market.
Gold was the answer in history for equity-bear-market negative-real-rate environments and it is also the answer today. As savers continue their flight out of cash-type investments and the US dollar in general to avoid the immoral stealth taxation via inflation, gold will continue to be one of the prime destinations for capital. A spectacular new gold-bull upleg is relentlessly approaching!
If you are wondering how to play this coming gold upleg as an investor, one of the best ways in terms of risk and potential rewards is via quality unhedged gold stocks. In the new April issue of our acclaimed Zeal Intelligence newsletter just published, I outlined and recommended our initial five gold-stock picks for the next stage of this wondrous gold bull.
Our April newsletter also describes how to avoid being buffeted by dangerous short-term emotions in emotional market times such as the ones we face today. If you honor us with a subscription to our e-mail PDF version of Zeal Intelligence to support our research, we will promptly send you a complimentary issue of this brand new ZI.
The bottom line is that the gold bull is almost certainly regrouping for its next awesome upleg after a healthy pullback. With today’s real interest rates massively negative, investment demand for gold from savers worldwide is only bound to increase regardless of the timetable or outcome of the Iraq war.
Adam Hamilton, CPA April 4, 2003 Subscribe at www.zealllc.com/subscribe.htm