Real Rates and Gold 7
Adam Hamilton May 28, 2004 3254 Words
With gold falling 12% and the HUI gold-stock index plummeting 29% from early April to mid May, it has been a tough couple of months for gold investors. The technical weakness in prices has been very intense at times.
In fact, in April three distinct and vicious plunges in the HUI so battered various technical studies based solely on gold-stock prices that some trading models are predicting the equivalent of gold-stock Armageddon. Prices plummeted so unbelievably fast that at least one popular speculation system is suggesting that an unprecedented 90% crash in gold-stock prices is probable!
As the all-time high in the HUI of 257 was just achieved early last December, a 90% drop in this flagship unhedged gold-stock index would yield a bone-shattering HUI low of 26 or so. How incredibly low is this? Well, in November 2000 when this gold-stock bull first started sneaking northward, the HUI fell under 36 for a day. So a 90% HUI Armageddon would pummel this index far below even its all-time Great Bear low of late 2000. Yikes.
Could such an event really happen? It sure could. The markets are nothing more than a giant study in probabilities. As probability theory states, there is nothing with a probability of one, a certainty of happening, and nothing with a probability of zero, a certainty of not occurring. There never have been and never will be any certainties in the financial markets.
While I believe that a 90% plunge in gold stocks from here likely has a probability approaching zero, it is not zero. Even though it is improbable, it is certainly possible with the right combination of events. As a gold-stock investor and speculator myself though, I have to admit that I am not at all worried about such a staggering development. Why? One of the primary reasons is I perceive an enormous technical and fundamental disconnect right now.
Technical analysis, the art of analyzing the markets based on price data alone, does not operate in a total vacuum. I am a huge fan of technical analysis, having written hundreds of essays analyzing prices as well as developed many of my own technical tools from scratch in order to attempt to execute superior trades. Yet, technical analysis must be considered within the strategic fundamental market context.
Technical analysis is tactical, focusing on making tough real-time trading decisions within short time frames. Fundamental analysis on the other hand, which compliments technical studies beautifully, is strategic in nature. Fundamental analysis focuses on the prevailing long-term trends that are acting over years and the real-world supply and demand forces driving them.
One analogy that nicely describes the interplay of fundamental and technical studies involves driving a car. When you drive a car, you darned well better be able to see out the windshield so you can make instant decisions about when to steer, accelerate, and brake. Your survival depends on you being able to react to current conditions rapidly and chart a safe course through countless random risks. Technical analysis has a similar tactical focus on the immediate.
Yet, even while you concentrate on driving, you also need a broad strategic plan. You can steer, accelerate, and brake all you want, but if you don’t know your final destination then the whole exercise is pointless. The idea of driving is to get you from point A to point B, but you need to know in advance where you are going. All of the tactical driving decisions you make in real-time contribute to you ultimately reaching your destination. Fundamental analysis has a similar strategic focus on the big picture.
Relying exclusively on tactical technical analysis without considering strategic fundamentals is like driving a car with no idea of where you want to end up. You can be driving along, see an accident, properly and prudently quickly react tactically to steer around and avoid it, yet still end up lost in the middle of nowhere. I believe a similar tactical and strategic disconnect is happening in the gold-stock world.
Gold and gold-stock prices have indeed been exceptionally weak in recent months and it is no wonder so many technical trading systems are throwing up all kinds of red flags. Yet, we need to consider the strategic fundamental context in which this weakness occurred. While there are many fundamental factors to consider, one of the most important is the relationship between the price of gold and real inflation-adjusted interest rates.
I penned my first “Real Rates and Gold” study in July 2001, when gold was still trading in the $260s near its long-term Great Bear bottom. The central fundamental thesis of these studies is that the most favorable monetary environment possible for gold is one where the rate of inflation exceeds the nominal short-term interest rates. When real rates are negative, investors actually lose purchasing power and grow poorer every year simply by holding short-term bonds.
If you are not familiar with the dire implications of negative real rates for investors and savers, you may wish to skim my last update of this negative real rates study, “Real Rates and Gold 6” published in January. Rather than again walk this well-traveled ground of discussing why negative real rates naturally lead investors into gold, this week I would like to use them to offer a bullish fundamental argument that easily trumps the recent weak technicals.
Regardless of the recent technical carnage, the price of gold is not likely to head lower in a negative real rate environment. And gold stocks are nothing more than leveraged proxies on the price of gold. If gold is driven higher by negative-real-rate induced buying, then gold-stock profits will soar ultimately driving up gold-stock prices. The only way that a gold-stock Armageddon is even possible is if gold utterly collapses, and as I think you will agree after studying these graphs this is a very unlikely proposition.
Both of these charts are the latest updates of the original July 2001 real rates and gold graphs. Just as they provided very powerful evidence that a gold bull was being born three years ago, they are very unambiguous today in predicting much higher gold prices as more investors flee the negative real yields of short-term bonds and seek refuge for their capital in the Ancient Metal of Kings.
Real interest rates are calculated by subtracting the annual change in the US Consumer Price Index from the yield on one-year US Treasury Bills. When they are positive, investors can increase their purchasing power every year by investing in short-term bonds. This is the natural state of the markets, where investors are rewarded for accepting risk.
When real rates are forced negative however, the mere act of investing leaves investors poorer every year as general prices increase faster than their invested capital. This is an unnatural and very harmful financial environment caused by central-bank manipulation of the price of money, or short-term interest rates. Negative real rates ultimately spawn huge capital shifts that can dramatically alter the investment landscape.
As you can see above, the greatest gold bull markets in modern history occur when real interest rates are either negative, or threatening to go negative, or rapidly falling. Gold tends to be the strongest when real rates of return on debt investments are the weakest. At these peculiar times in history when deploying capital in short-term debt assures a real loss of purchasing power, investors flee to gold for refuge and drive up its price.
Also intriguing from this long strategic perspective, gold bulls only seem to weaken and end when real rates shoot massively positive, to at least 3% and often above 4%. If real rates in the United States were heading through +3% today, then the fundamental case for gold would be very bearish. But, with real rates currently still negative for the first extended period since the 1970s gold superbull, today’s real rate environment remains supremely bullish for gold.
As you examine the chart above, pay careful attention to every major downleg in the Ancient Metal of Kings. You will notice that major persistent gold price weakness generally does not occur in modern history when real rates are negative. This fundamental piece of the gold puzzle is very important. If one was so intensely focused on technicals alone that they ignored all fundamentals, then they would have no idea that gold is currently sojourning in the most bullish monetary environment in decades.
In order for the gold-stock Armageddon to unfold that some purely technical trading systems are predicting today, the gold price has to plummet. But, gold has never entered a major downleg in modern history when real rates are negative, with the curious exception of the mid-1970s. But even in that case, gold corrected temporarily only when negative real rates were skyrocketing higher and striving for positive territory. There is no similar massive spike up in real rates today and therefore no monetary catalyst for this gold bull to fail here.
If gold is not about to plummet, then there is also no sound argument possible for a massive worldwide liquidation of profitable unhedged gold producers. Whenever there is a conflict between short-term technicals and long-term fundamentals, the powerful supply and demand fundamentals almost always prevail. There is simply no historical reason to expect our gold bull to end in the current negative real rate regime that we are suffering through in the States.
Even if you are willing to concede the unlikelihood of a gold and gold-stock collapse while real rates remain negative, the next logical question to ask is when will real rates again shoot positive and threaten gold? Our second chart zooms in to the past four years or so to help us address this crucial question.
This shorter-term chart really illuminates a lot of important insights on both our current gold bull and the interplay between inflation and T-Bill yields that has driven real rates negative for the first time since the 1970s. If real rates are to soar higher and threaten the gold bull and slaughter gold stocks like lambs, then there are only two possible ways for this to happen. Either the Fed raises nominal rates massively or inflation in the US plummets to zero.
The blue and red real rates line, as mentioned above, is calculated by subtracting the white annual-change-in-the-CPI inflation line from the black one-year-Treasury-Bill-yield line. In order to force real rates to rocket positive and threaten the gold bull, the Fed could dramatically raise the price of money by jacking up short-term interest rates, the black line, like there was no tomorrow. Is such a scenario likely?
Even if you happen to be one of the many folks who believe that the Fed somehow mystically controls the US financial markets like the Wizard of Oz, you have to admit that a huge surge in real rates is extremely unlikely. Actually short-term rates are the only thing the Fed really does directly control, and if it wanted to it could probably force rates higher in a short period of time to help end the negative real rate madness. But, due to the huge magnitude of the rate hikes required to pull this off, such a course of action would not only hurt gold but decimate stocks, bonds, and residential real estate. It may even spawn another Depression.
Recall from above that real rates in the +3% to +4% range are generally needed to entice capital back out of gold and into bonds in a big way. And not only do real rates have to go this high, in order to be enticed to act investors must be convinced that the Fed intends to keep nominal rates high for a long enough period of time to maintain massively positive real rates. Assuming that inflation remains constant at the low 2% to 3% range, the Fed would have to ratchet up short rates enough to push one-year Treasury yields to the 5% to 7% range to hit 3% to 4% real!
With the overnight fed funds rate that the Fed directly controls now hovering at the unnaturally low level of 1% today, we would probably need the FOMC to issue a kamikaze series of rates hikes in rapid succession until this overnight rate exceeded 4%. Anything less and it is unlikely that one-year T-Bill yields would trade high enough to bring back massively positive real rates and end the merciless attack on investors’ capital.
Now if overnight rates soar from 1% to 4%, can you imagine what this would do to the stock markets, the bond markets, residential real estate, and the US economy? Talk about financial Armageddon, this might be it! This magnitude of a Fed move from such unnaturally low rates would quadruple the overnight price of money and probably double or triple the costs of borrowing for the average business or consumer. Even if it only doubles interest payments, the impact over our entire debt-laden economy of twice as much cash heading into debt service would be staggering.
Stock prices would plummet, perhaps even crash if the quadrupling of rates was fast enough. Overall corporate profits would decline precipitously as today’s thin profit margins in such a competitive global landscape were further squeezed with higher interest payments. In addition to absolute profits falling, all the Wall Street folks who still believe in the discredited interest-rate stock valuation models would be forced to lower their acceptable P/E ratios for the general markets.
And while things would certainly look ugly in stocks, bond investors holding existing lower-yielding bonds would be eviscerated by a quadrupling of the short rates. As interest rates go up, existing bonds are sold off until they have lost enough face value to effectively yield the new higher market rates. While this is great for bond investors buying new bonds, investors holding existing bonds would watch in horror as their principal furiously eroded.
And in residential real estate, today’s whole mania in housing prices is totally dependent on the notion that home costs can rise forever as long as new buyers can borrow the huge sums necessary at cheap interest rates. As unnaturally low interest rates are the linchpin holding the fragile spiraling housing market together, if the Fed quadruples short rates this game is over. As mortgage costs doubled, the amount of debt Americans could carry would plunge and housing prices would crash.
Thus, regardless of how little the Fed happens to like gold, the costs of quadrupling short rates to bring real rates massively positive are staggering and far too high. No rational bureaucrat who values his future would risk crushing stock, bond, and real estate investors simultaneously just to end a gold bull. While nominal rates will rise gradually, negative real rates are likely to persist for a long time to come yet and are very bullish for gold. The black 1y T-Bill line above is not likely to skyrocket to 5% to 7% anytime soon.
The only other alternative to spawn positive real rates of 3% to 4% is for inflation in the US to plunge. The white YoY CPI line above would have to magically journey below zero, however, in order to see real rates even approach positive 3%. What are the odds of US inflation plunging to nothing? Probably as close to zero as one can get in the financial markets!
Since 1971 when the US dollar gold standard was terminated by the Nixon regime, money supplies in the States have been relentlessly ballooning. Inflation is caused by relatively more money chasing after relatively fewer goods and services. In order for inflation to fall moderately, let alone fall to nothing, the Federal Reserve would have to quit creating new money for years in order to sop up the current huge excesses of fiat dollars. Such an event has never happened before.
In just the past year alone, the Fed has grown MZM money by 5.1% and broad M3 money by 5.6%, the true US inflation rates. These new dollars, as always in history, eventually start bidding up prices in the US economy. The reason that everything from homes to cars to food costs much more than a decade or two ago is because of fiat-currency inflation. The Fed could conceivably stop adding money to our system, but it isn’t going to happen. Debt-based fiat-currency regimes like our current example in the US must either expand perpetually or fail catastrophically. History is very unambiguous on this.
So, our current negative real rate environment, which is so bullish for gold, has been spawned by the Fed. At the very same time it continues to pump new dollars into the US economy which bid up prices, it has forced interest rates to unnatural nearly half-century lows in a foolish attempt to bail out the bubble stock-market speculators of the late 1990s. To now mess dramatically with either the low rates or monetary growth could certainly spark a systemic crash of epic proportions.
If the Fed cannot raise nominal rates high enough fast enough to push real rates positive, and if it cannot quit creating money to eliminate inflation, then real rates in the US are going to remain negative for some time to come. And there is no more bullish monetary environment for gold and hence gold stocks then these rare negative real rate episodes. Note on this chart how our current gold bull didn’t start until real rates threatened to plunge negative for the first time in decades.
Coming full circle, the technical prophecies of gold-stock doom are focusing on price alone, as all pure technical analysis does. But, the problem is technical analysis done in a total fundamental vacuum can be really misleading. Extremely positive supply and demand fundamentals can trump ugly technicals any day.
Gold stocks ultimately depend solely on the price of gold. As gold goes higher so do their profits and eventually their stock prices. In order for gold stocks to fall off the face of the earth as some technical studies suggest, the gold bull itself has to fail. But gold bulls generally do not end until real interest rates shoot massively positive. But in order to make real rates massively positive to lure capital back out of gold, the Fed would have to slaughter stocks, bonds, real estate, and probably the US economy simultaneously. Highly unlikely to say the least.
Technical analysis is highly valuable and tremendously useful. But it needs to be viewed within the overarching strategic fundamental context of the markets. Using technical analysis exclusively without considering the background supply and demand context is like driving with no destination in mind. The probability of getting lost and missing fantastic opportunities is quite high.
Our acclaimed monthly newsletter, Zeal Intelligence, attempts to integrate cutting-edge technical analysis with battle-tested fundamental analysis in order to maintain the crucial strategic perspective while we strive to execute tactically superb gold-stock trades. Please join us today to learn how to profit from this awesome ongoing gold bull!
The bottom line on this latest negative real rates update is that the powerful bull market in gold is almost certainly not over yet with real rates likely to remain negative for a long time to come. Periodic sharp corrections in bull markets are healthy and expected, and that is exactly what we have just witnessed in gold stocks.
Please beware of technical analysis operating in a total fundamental vacuum, taking it with a grain of salt and keeping the whole strategic picture in focus.
Adam Hamilton, CPA May 28, 2004 Subscribe at www.zealllc.com/subscribe.htm