Real Rates and Gold 5
Adam Hamilton September 19, 2003 3189 Words
One of the most often ignored yet most important strategic drivers of the financial markets is the prevailing real-interest-rate environment. Real interest rates profoundly impact the whole spectrum of major financial markets and dramatically influence collective investor behavior.
As real rates are simply the market interest rates less the rate of inflation, this week witnessed some big news on the real-interest-rate front. On Tuesday the monthly release of the US CPI numbers happened to coincide with the interest-rate-policy meeting of the Fed’s FOMC. Both inflation and nominal rates were big financial news on the same day, yet still the resounding financial-media silence on real rates remained deafening.
Real rates are important and need to be studied and understood if one is to thrive as an investor, but it is so hard not to wax cynical whenever considering their heavily manipulated components. Neither the one-year nominal US Treasury interest rates nor the reported CPI inflation numbers are true free-market products, as both suffer from heavy and overbearing government pressure or outright official manipulation.
Just like in the old Soviet Union, today the US Fed actively manipulates short interest rates. Sadly few free-market capitalists complain about this abomination, and indeed many professing capitalists celebrate the Fed’s bumbling ineptitude of brazenly trying to do a better job of setting short rates than the free markets alone could.
A bunch of mere mortals at the Fed meet behind closed doors in secret, like the mafia or a conspiratorial cabal, and magically decide what the “best” ultra-short rates for the entire US economy should be. It is sheer madness! True, the Fed doesn’t directly outright set the crucial one-year Treasury nominal interest rates we need to compute real rates, but its heavy-handed bludgeoning of the very short end of the yield curve certainly heavily influences the key one-year Treasury rates.
Now that we are over a dozen ineffective rate cuts into this supercycle bubble bust, one would think that the free-market capitalists would realize that the Fed is worthless at best, and an immensely destructive engine of confiscatory fiat-currency inflation at worst, but so far the institution strangely remains widely celebrated. It is hard not to be cynical when considering the abomination of the Fed and what a mockery its closed-door-Politburo pegging of short rates makes of free markets. Central Planning at its worst!
And after you shake your head in disgust at the Fed’s futile machinations, think about the charade that is the US Consumer Price Index! The bureaucratic statistical wizards computing the CPI each month want to please their political masters so the index is so watered down and irrelevant it is almost useless. Statistical sleight-of-hand tricks underweight rising prices and overweight rare falling prices in order to keep the CPI politically palatable for government politicians.
Crucial non-negotiable life-necessity expenses, like food, shelter, and energy, are drastically underweighted or eliminated outright from hybrid CPI concoctions such as the so-called “Core CPI”. Yet, as every American sadly knows, our general costs of living rise relentlessly without fail year after year. Each year we all spend more on groceries, homes, energy, education, and health care, yet the government continues to try to convince us that inflation is trivial. What a cruel joke!
Take a look at your own historical financial records from late last decade and it will blow your mind how much basic prices in everything have risen, even though the official CPI continues to claim that inflation is well under control. Every American, when they really think about it, instinctively knows that we are paying a lot more for basic living each year even though the government blissfully claims that prices are barely rising.
Unfortunately to compute real interest rates we have to rely on both the one-year Treasury nominal rates, which are heavily influenced by the Fed’s Communist-style price fixing of overnight rates, and the horrifically biased CPI, which is no longer credible but just a politicians’ plaything since the statisticians computing it will be out of jobs if the real inflation numbers are too high for political acceptability.
Please forgive me for my cynicism, but as a lover of truly free markets and honest numbers the Fed’s indirect badgering of one-year rates and the government’s chronic underreporting of the CPI are unacceptable abominations. Whenever any government seeks to get involved in any market the end results are always bad, a huge misallocation of scarce resources and an inevitably ugly day of reckoning when the free markets smash the government interference into oblivion.
But nevertheless, the one-year Treasury rates and the year-over-year change in the CPI remain the best inputs we have for the real-interest-rate equation today, so gaping flaws and all they must be used.
As I have been discussing for years now, real interest rates in the US are now negative. This means that any saver/investor who buys any short-term debt investment running one year in duration or so is guaranteed to lose real purchasing power. In negative real-rate environments, short-term debt investing (saving) actually makes one poorer on balance, not wealthier! The economic world is turned upside down and savers and investors are gutted by negative actual returns.
If you are not comfortable with the crucial concept of negative real interest rates, you may wish to skim some of my earlier essays on this important subject. The latest one was “Real Rates and Gold 4”, which was published in early April of this year. While most paper investments like stocks and bonds tend to suffer dearly over the long-term in a negative real-rate environment, precious metals tend to thrive.
Indeed, the best gold and silver performance in modern history coincides with these rare episodes of negative real rates. It makes sense too! If the government mucks around with money supplies and interest rates so much that it guarantees investors will lose wealth and purchasing power through the mere act of saving, the investors soon wise up and seek to place their money elsewhere. Gold is the ultimate safe haven during these times when inflation exceeds the nominal interest rates that one can obtain in the marketplace.
Both of our graphs this week are current updates from my previous essays in this series and dramatically illustrate this key point. When gross monetary mismanagement by the government and Fed pushes real rates of return negative, investors flee into gold. Period. This massive shift of capital starts slowly at first, but as more and more investors wake up to the outright government hostility to their capital the shift accelerates dramatically. This is readily apparent on the grand strategic scale of the last few decades or so.
Negative real rates are a relatively rare phenomenon indeed! The last major episode prior to the one through which we are sojourning today happened in the 1970s, as the red negative real-rate line above illustrates. Anytime real interest rates even flirt with negativity, such as in the early 1990s, investment buying in gold accelerates dramatically as prudent investors try to wisely protect their hard-earned capital from government inflationary predation.
When real rates are positive, as they always should be, there is a sense of financial justice and parity between savers and debtors. Both savers and debtors can voluntarily enter into mutually beneficial transactions, with debtors paying a fair rate for borrowing someone else’s capital and savers earning a fair rate of return on their own hard-earned savings. In these normal positive real-rate environments, both stocks and bonds tend to do well since actual positive real returns can be earned in these intangible paper instruments.
But when the Fed prints too much paper money, and the government spends too much on guns and butter, and interest rates are actively manipulated lower to paint a false picture of the current monetary situation, all this conventional investment wisdom that served investors so well in the 1980s and 1990s is thrown out the window. Inflation exceeds the short-term rate of return for savers and soon they are relentlessly hemorrhaging purchasing power.
The balance of power between debtors and savers is temporarily artificially badgered over to the debtors’ side of the scale. Savers react slowly but surely by doing the only rational thing possible. Rather than lending their scarce capital out at a guaranteed loss in these negative real-rate episodes, they simply gradually stop lending and instead park their money in tangible inflation hedges like gold. Riding out the monetary storm with one’s capital intact is always a far better strategy than being kicked in the teeth by inflation!
And the long-term gold graph above indeed reflects this behavior by savers when real rates turn negative. I don’t think it is a coincidence at all that today’s bull market in gold began just as real rates threatened to plunge negative again for the first time in a decade in early 2001. Investors have gradually read the writing on the wall and more and more are buying gold since they can no longer earn a fair return in the cash and short-term debt markets. When the abominable Fed declares war on innocent savers, savers turn to gold!
In addition, just as in the 1970s, odds are that this powerful bull market in gold today will run unabated until real interest rates shift massively positive as they did in the early 1980s. Once folks realize a negative real-rate environment exists, they get used to it and expect more of the same.
Today’s prudent investors who understand the immense danger of negative real rates to their wealth will not be willing to shift out of their newly deployed gold positions until real rates spike into the heavens and stay there for a year or more. After being scammed by the Fed with negative real rates, investors demand proof and concrete action that the Fed is changing its nefarious anti-capital ways before they migrate back out of gold. Talk is cheap.
From a long-term strategic gold-investor standpoint, one of the key warning signs to watch for that would signal that the gold bull’s days are probably numbered is an enormous increase in real interest rates far into positive territory. Since inflation in a fiat-monetary regime never falls under zero, new money is always being printed, the only way we could see massively positive real interest rates is if nominal market interest rates rocket majestically skyward again like they haven’t for two decades.
Until this sign emerges though, odds are that more and more investors will move their capital into gold for refuge from the ugly negative-real-rate inflationary confiscation of their wealth. As you can see on the chart above, real rates remained a good distance under zero as of the end of August. I personally need to know where real rates stand at least monthly, and I like to update our real-rates charts at least twice a year to keep things in proper perspective.
The longer that real rates remain negative, and the deeper that they plunge into negative territory, the longer and more powerful our gold bull today is going to grow. Great Bulls in gold voraciously feed off of negative real interest rates, and the pickings today for our gold bull to feast upon and grow mighty are abundant thanks to the government and the Fed.
Zooming into a more tactical scale of only a few years or so, the powerful relationship between the gold bull and the negative real-rate environment is even more apparent. Unlike our monthly graph above, this one uses daily data, except for the monthly-only CPI. This gold bull began when real rates merely threatened to plunge negative, and every day that they remain negative our gold bull is growing in strength and power.
As much of this chart was discussed in “Real Rates and Gold 4”, I would like to focus in on the new portions this time around, basically the last six months or so of fresh data. Since that essay of early April, real rates plunged even farther negative before suddenly surging higher yet still remaining well-entrenched in confiscatory negative territory.
The nearly 1% surge in real rates near the end of the first quarter was very interesting. While real interest rates typically migrate around rather slowly, this big jump happened in the blink of an eye. Provocatively a major pullback in the gold bull corresponded with this surge in real rates, which also happened to be around the launch of Washington’s annexation of Iraq. While any increase in real rates is a good thing for savers and investors, if we dissect this particular jump by analyzing its components this surge was fueled in the worst possible way.
As I mentioned earlier in opening, real interest rates are calculated by subtracting the rate of inflation from the nominal interest rates available to savers in the markets. These two equation ingredients must also be over the same time frame to be comparable, and one year is the intuitive and obvious time point at which real rates are always measured.
The chart above shows these two real-rate ingredients over time, the 1-Year T-Bill rate in black and the annual percentage change in the CPI in white. The large surge in real rates earlier this year was not the result of higher interest rates available to savers, a good thing, but a sharp fall in the year-over-year growth rate in the government-calculated CPI index, a dubious development at best.
As the white CPI line indicates, since early 2002 the CPI uptrend in terms of percentage change had been very well-defined. The CPI had climbed from an unbelievably (literally unbelievable) low level around 1% in early 2002 up to a far more plausible yet still low-balled 3% growth rate in early 2003. Then it suddenly fell off a cliff at the end of Q1 and vaulted real rates higher right in time for Washington’s invasion of Iraq.
Now inflation is truly defined as absolute growth in the money supply, and there is no doubt that the monetary rate of inflation in the United States is vastly higher than a few percent. Indeed, per the latest data directly from the Federal Reserve, the entity itself claims that it is actively growing the dollar supply far faster than the heavily biased CPI would suggest.
Per the Fed itself, currently M1, MZM, M2, and M3 have grown by an absolute 7.2%, 8.4%, 7.7%, and 7.4% respectively over the past year. Yet the government now claims that consumer inflation is merely running 1% to 3%? No way! Consumer prices simply cannot only be increasing at only 1/8th to 2/5th of the rate of monetary growth, as this is contrary to all of economic history and experience. Yet, the government expects us to naively believe this.
Inflation is fairly easy to test for yourself though. Most folks these days use software like Quicken to track their personal finances. If you do that, all you have to do is punch up a report to see how much you are spending on any essential life-expense category today, like food, shelter, and energy, compared to a few years ago. If the government 3%ish CPI is correct, you should see general expense numbers about 13% higher than 4 years ago (mid-1999). Odds are your bills have gone up by much more than that though!
If the 7%ish Fed numbers are more right, general expenses are probably around 31% higher today than 4 years ago on average for the American people. In my own case, and speaking for almost all of my friends and clients that I have spoken with about general inflation, the latter 31% rise over 4 years is much closer to the truth than 13%. The CPI is chronically low-balled for political reasons, but most Americans still instinctively know that the same number of dollars today goes much less farther than it did only a few years ago.
Back to real rates, the rise in real rates earlier this year was not due to higher market rates, but a sudden drop in the annual growth rate in the CPI. A mystical reported government number, probably pulled out of a hat for all I know, was responsible for this entire real-rate increase. The much-more free-market oriented 1-Year T-Bill rate, even though heavily bullied by the Fed’s active manipulation on the ultra-short-end of the yield curve, barely budged at all. Indeed market rates attainable at a one-year maturity even fell lower for another quarter before carving an interim bottom!
So the real rates rose because the CPI mysteriously plunged. No free-market activity was involved at all, just hedonically deflated government statistical releases! And when the CPI’s gross lack of accountability and credibility for actually tracking the prices of the necessities that we Americans need to buy in order to live is considered, it is hard to get too excited about the real-rate increase in the past couple quarters.
In reality, since consumer inflation is probably running much closer to the 7%+ Fed inflation of the supply of US dollars used to buy consumer goods and services, odds are the real rate is even far more negative now than the graph above indicates. Lying about inflation is useless over the long-term, because it will become apparent to all even if the government tries to claim that it doesn’t exist. Trying to hide an elephant under a living-room rug may work for a short season, but soon it will become apparent to all what is really happening in the economy.
Even with the surprising fall in the CPI, real rates still remain officially negative however, which is a fantastic omen for the unfolding gold bull. In the 1970s the gold bull continued growing in power, indeed accelerating, until real rates went massively positive long enough to convince battle-scarred investors that the threat of inflation was indeed contained for the time being. Today we have the opposite situation, where inflation is looming yet most don’t know it yet since they believe the diversionary deflationary hype so widely currently spewed by the Fed, government, and media.
While gold and silver thrive in hostile negative real-rate environments, stocks and bonds suffer horrifically. Ironically I often hear people today claim that inflation is good for stocks, which always makes me shake my head and laugh. Apparently they conveniently forgot the 70s! The highly inflationary 1970s and early 1980s were some of the worst periods for the equity markets in modern memory. The threat of inflation utterly slaughters all intangible investments, including stocks and bonds, without mercy and with extreme prejudice.
As long as real rates remain negative, investors would do well to avoid general stocks and bonds and take refuge in gold. Eventually the free markets will force real rates positive once again regardless of government/Fed squealing, as happened in the early 1980s, but until then savers are being stealthily robbed through inflation rates running well above the nominal interest rates attainable in the markets.
Why subject your hard-earned scarce capital to another stealth tax? Beat the rush and get into gold now, and then you can sell out near the top right as real rates start to rocket into the heavens once again.
Adam Hamilton, CPA September 19, 2003 Subscribe at www.zealllc.com/subscribe.htm