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Old 08-08-2012, 05:26 PM   #1
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Lightbulb Gold's INVERSE correlation with interest rates (Gibson's paradox)

This is a bit of a theoretical issue but it's useful for gold investors. Ultimately this thread is about the inverse correlation between gold prices and real (inflation-adjusted) interest rates.

This discovery derives from the so called "Gibson's paradox"
Quote :
Gibson's Paradox is the observation that the real rate of interest and changes in the general level of prices are positively correlated. It is named for British economist Alfred Herbert Gibson who noted the correlation in a 1923 article for Banker's Magazine. The correlation had been noted earlier by Thomas Tooke.

The term was first used by John Maynard Keynes, in his 1930 work, A Treatise on Money. It was believed to be a paradox because most economic theorists predicted that the correlation would be negative. Keynes commented that the observed correlation was "one of the most completely established empirical facts in the whole field of quantitative economics."

The Quantity Theory of Money predicts that a slower money-growth creates slower price-rise. In addition, slower money-growth means slower growth of loanable funds and thus raises interest rates. If both these premises are true, slower money-growth should mean lower prices and higher interest rates. However, Gibson observed that lower prices were accompanied by a drop—rather than a rise—in interest rates. This is the paradox that needs to be explained. For instance, in the 1873-96 depression, prices fell considerably while interest rates remained low. Economist S.B. Saul says that Alfred Marshall explained the paradox by saying that other factors might have been at play: a peace dividend and improving international system of banking and finance.

Economists held the view that the interest rate was correlated to the rate of inflation whereas Keynes' findings contradicted this view. During the period of gold standard, he observed that interest rate was correlated to the general price level, and not the rate of change in the prices. In fact, he thought that interest rate was highly correlated to the Wholesale Price Index rather than the rate of inflation.

The key here is that this happened under the gold standard, i.e. with a fixed gold price.

The scientific text that showed how free floating gold prices (i.e. under a fiat money regime) are inversely correlated was written by none other than the one and only Larry Summers
(former Treasury secretary under Clinton: ) together with Robert Barsky. It's posted on GATA's website:

The rule states that for every percentage point the real interest rate is below 2%, gold returns 8% year-on-year times that multiple. (example see below)

Hinde Capital has recently picked this research up and shown that gold is currently undervalued given the negative real interest environment that we're in:

Quote :
Gold has been caught in a very tight range since the 16% rally at the start of the year and the subsequent sharp sell off in late February and March. Often when prices in any asset become compressed, they invariably break out of the range emphatically. With gold, the fundamentals remain supportive which suggests that gold should break out from its range to the upside.

Specifically, global liquidity conditions are very accommodative and global interest rates are being lowered ubiquitously.

Currently, the VP Expected Real Interest Rate is -2.75% which implies a subsequent year-on-year return for gold of over 20%.

Furthermore, gold is strongly underperforming relative to the rule of thumb provided by Gibson’s Paradox

The rule states that for every percentage point the real interest is below 2%, gold returns 8% year-on-year times that multiple. Real rates are currently -1.45%, which implies a 28% performance for gold over the next year.
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Old 12-02-2012, 09:27 PM   #2
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More on Gibson's Paradox:

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Gibson's Gold Law
Gibson's Paradox - Revisited
Chris Gilbert Waltzek
November 29, 2012

While preparing for this week's Radio, my attention was drawn to a little known economic theory proposed by a British economist 90 years ago. In 1923 Alfred Herbert Gibson published a paper regarding the negative correlation between interest rates and inflation in Banker's Magazine (White, 2011). John Maynard Keynes later coined the term Gibson’s Paradox in 1930 (Keynes, 1930). Unlike his contemporaries, Keynes embraced Gibson’s finding as one of the most established and profound in the field of economics. I concur Gibson’s Paradox deserves to be recognized as an economic law, not merely a theory.

Subsequent researchers proposed that Gibson's Paradox explains much of the price movement in the gold market (Summers & Barsky, 1988). Research indicates that the gold price and real interest rates are highly negatively correlated - when rates go down, gold goes up. It has been rigorously back-tested and stands the test of time via not only theoretical evidence, but empirical research. In fact, regression analysis reveals a very high f-statistic which adds statistical support to the notion - when real interest rates are below 2%, a bull market in gold is virtually certain.

If experimental and experiential evidence validates Gibson's Paradox, how come the theory isn't widely recognized? It's likely that the mainstream media and academia have been reticent to accept and assimilate Gibson’s Paradox due to a simple misconception. The generally accepted real interest rate or rate of return is not negative, and so a gold bull market is not anticipated.

How should analysts / economists determine the real interest rate? The real interest rate is the nominal rate that investors expect to receive, i.e. the long term treasury bond coupon or rate less the inflation rate. Since the U. S. Treasury earns 3% per annum, the real interest rate is 3% minus the annual rate of inflation. John Williams’ indicates a domestic inflation rate of 6-8%. To verify his work, one can calculate the annual growth rate in the Treasury Inflation Protected Securities TIPS ETF from the IPO date in 2004 until 2012. The TIPS ETF indicates a 6% (approximate) annual inflation rate, very close to John Williams’ figure. So to determine the real rate of return, the 6% inflation rate is subtracted from the 3% treasury yield, resulting with a real interest rate of -3%.

Next, Gibson’s Paradox offers a gold price forecast for the next 12 months (White, 2011). The rule states that for every percentage point the real interest rate (-3%) is below 2%, gold will increase in value by 8%. As calculated in the last paragraph, the real interest rate is assumed to be -3%. Since -3% is 5% below the 2% threshold, 5 percentage points times 8% provides the gold forecast for the next 12 months: 5 x 8% = 40% . The current gold price is near $1,700 - leading to a gold price forecast of: $1,700 x 1.40 = $2,380. Anecdotally, $2,380 coincides with the 1980 inflation adjusted, peak gold price.

Maintaining a healthy modicum of skepticism is wise for every investor. Next a very cursory back-test of Gibson’s Paradox is illustrated in Figure 1.1. Assuming that rates entered negative territory in 2001 and have remained there ever since, resulting with a constant real interest rate of -0.5%, gold should have performed as follows:

Figure 1.1. Gibson’s Gold Law - Back-test:

2001: $300;
2002: $360;
2003: $432;
2004: $518;
2005: $622;
2006: $747;
2007: $895;
2008: $1074;
2009: $1289;
2010: $1547;
2011: $1857.

Do the numbers above look familiar? Clearly the back-test shows a high correlation to the true bull market price advance - Gibson’s Paradox holds. Assuming the same negative real interest rate of -0.5% (2.5% below the threshold resulting with 2.5 x .08 = 20% growth per annum) Gibson's Paradox provides a gold forecast in Figure 1.2 (White, 2011):

Figure 1.2. Gibson’s Gold Law - Forecast:

2012: $1,700 x 1.2 = $2229;
2013: $2229 x 1.2 = $2675;
2014: $2675 x 1.2 = $3210;
2015: $3210 x 1.2 = $3851;
2016: $3851 x 1.2 = $4622;
2017: $4622 x 1.2 = $5,547.

Therefore, if real interest rates remain even fractionally negative, given the precepts of Gibson’s Paradox, the price of gold should surpass $5,500 by 2017. However, there are many factors that can skew the actual forecast outcomes. For instance, the real interest rate is volatile, which will result in varied annual gold price forecasts. The Gibson Gold Forecast is intended only as a guide. Nevertheless, gold investors are urged to regularly calculate the real, inflation adjusted interest rate to verify that it is below 2% and particularly that it remains below 0%, to satisfy the ideal conditions for higher gold prices.

Quote :
A Possible Model for the Price of Gold
Posted by Eddy Elfenbein on October 6th, 2010 at 8:15 am

One of the most controversial topics in investing is the price of gold. Eleven years ago, gold dropped as low as $252 per ounce. Since then, the yellow metal has risen more than five-fold, easily outpacing the major stock market indexes—and it seems to move higher every day.

Some goldbugs say this is only the beginning and that gold will soon break $2,000, then $5,000 and then $10,000 per ounce.

But the question is, “How can anyone reasonably calculate what the price of gold is?” For stocks, we have all sorts of ratios. Sure, those ratios can be off…but at least they’re something. With gold, we have nothing. After all, gold is just a rock (ok ok, an element).

How the heck can we even begin to analyze gold’s value? There’s an old joke that the price of gold is understood by exactly two people in the entire world. They both work for the Bank of England and they disagree.

In this post, I want to put forth a possible model for evaluating the price of gold. The purpose of the model isn’t to say where gold will go but to look at the underlying factors that drive gold. Let me caution that as with any model, this model has its flaws, but that doesn’t mean it isn’t useful.

The key to understanding the gold market is to understand that it’s not really about gold at all. Instead, it’s about currencies, and in our case that means the dollar. Gold is really the anti-currency. It serves a valuable purpose in that it keeps all the other currencies honest (or exposes their dishonesty).

This may sound odd but every currency has an interest rate tied to it. In essence, that interest rate is what the currency is all about. All those dollar bills in your wallet have an interest rate tied to them. The euro, the pound and the yen also all have interest rates tied to them.

Before I get to my model, I want to take a step back for a moment and discuss a strange paradox in economics known as Gibson’s Paradox. This is one the most puzzling topics in economics. Gibson’s Paradox is the observation that interest rates tend to follow the general price level and not the rate of inflation. That’s very strange because it seems obvious that as inflation rises, interest rates ought to keep up. And as inflation falls back, rates should move back as well. But historically, that wasn’t the case.

Instead, interest rates rose as prices rose, and rates only fell when there was deflation. This paradox has totally baffled economists for years. Yet it really does exist. John Maynard Keynes called it “one of the most completely established empirical facts in the whole field of quantitative economics.” Milton Friedman and Anna Schwartz said that “the Gibsonian Paradox remains an empirical phenomenon without a theoretical explanation.”

Even many of today’s prominent economists have tried to tackle Gibson’s Paradox. In 1977, Robert Shiller and Jeremy Siegel wrote a paper on the topic. In 1988 Robert Barsky and none other than Larry Summers took on the paradox in their paper “Gibson’s Paradox and the Gold Standard,” and it’s this paper that I want to focus on. (By the way, in this paper the authors thank future econobloggers Greg Mankiw and Brad DeLong.)

Summers and Barsky explain that the Gibson Paradox does indeed exist. They also say that it’s not connected with nominal interest rates but with real (meaning after-inflation) interest rates. The catch is that the paradox only works under a gold standard. Once the gold standard is gone, the Gibson Paradox fades away.

It’s my hypothesis that Summers and Barsky are on to something and that we can use their insight to build a model for the price of gold. The key is that gold is tied to real interest rates. Where I differ from them is that I use real short-term interest rates whereas they focused on long-term rates.

Here’s how it works. I’ve done some back-testing and found that the magic number is 2% (I’m dumbing this down for ease of explanation). Whenever the dollar’s real short-term interest rate is below 2%, gold rallies. Whenever the real short-term rate is above 2%, the price of gold falls. Gold holds steady at the equilibrium rate of 2%. It’s my contention that this was what the Gibson Paradox was all about since the price of gold was tied to the general price level.

Now here’s the kicker: there’s a lot of volatility in this relationship. According to my backtest, for every one percentage point real rates differ from 2%, gold moves by eight times that amount per year. So if the real rates are at 1%, gold will move up at an 8% annualized rate. If real rates are at 0%, then gold will move up at a 16% rate (that’s been about the story for the past decade). Conversely, if the real rate jumps to 3%, then gold will drop at an 8% rate.

Here’s what the model looks like against gold over the past two decades:

The relationship isn’t perfect but it’s held up fairly well over the past 15 years or so. The same dynamic seems at work in the 15 years before that, but I think the ratios are different.

In effect, gold acts like a highly-leveraged short position in U.S. Treasury bills and the breakeven point is 2% (or more precisely, a short on short-term TIPs).

Let me make this clear that this is just a model and I’m not trying to explain 100% of gold’s movement. Gold is subject to a high degree of volatility and speculation. Geopolitical events, for example, can impact the price of gold. I would also imagine that at some point, gold could break a replacement price where it became so expensive that another commodity would replace its function in industry, and the price would suffer.

Instead of explaining all of gold, my aim is to pinpoint the underlying factors that are strongly correlated with gold. The number and ratios I used (2% break-even and 8-to-1 ratio) seem to have the strongest correlation for recent history. How did I arrive at them? Simple trial and error. The true numbers may be off and I’ll leave the fine-tuning for someone else.

In my view, there are a few key takeaways.

The first and perhaps the most significant is that gold isn’t tied to inflation. It’s tied to low real rates which are often the by-product of inflation. Right now we have rising gold and low inflation. This isn’t a contradiction. (John Hempton wrote about this recently.)

The second point is that when real rates are low, the price of gold can rise very, very rapidly.

The third is that when real rates are high, gold can fall very, very quickly.

Fourth, there’s no reason for there to be a relationship between equity prices and gold (like the Dow-to-gold ratio).

Fifth, the TIPs yield curve indicates that low real rates may last for a few more years.

The final point is that the price of gold is essentially political. If a central banker has the will to raise real rates as Volcker did 30 years ago, then the price of gold can be crushed.

Technical note: If you want to see how the heck I got these numbers, please see this spreadsheet.

Column A is the date.
Column B is an index of real returns for T-bills I got from the latest Ibbotson Yearbook. It goes through the end of last year.
Column C is a 2% trendline.
Column D is adjusting B by C.
Column E is inverting Column D since we’re shorting.
Column F computes the monthly change the levered up 8-to-1.
Column G is the Model with a starting price of $275 (in red).
Column H is the price of gold. It goes up to last September.
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Old 12-03-2012, 03:35 PM   #3
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Great stuff! Thanks for posting
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Old 12-04-2012, 06:21 AM   #4
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...guys YOU are the gold mine!!!

I mean, this is something I grasp intuitively (ie, if I don't see any return on my money, when I store it in the bank, which in turn, makes shitload of money, using it as a reserve & lending it out - why should I be so kind to them, and supply them with that free ride fuel - instead of stuffing my mattress with something, that WILL yield something to me), but having it laid out like that, and having numbers crunched empirically... Priceless!
“...the issue which has swept down the centuries and will have to be fought sooner or later is the People versus the Banks.
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Old 12-04-2012, 08:42 PM   #5
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Originally Posted by bushi View Post:
...guys YOU are the gold mine!!!

I mean, this is something I grasp intuitively (ie, if I don't see any return on my money, when I store it in the bank, which in turn, makes shitload of money, using it as a reserve & lending it out - why should I be so kind to them, and supply them with that free ride fuel - instead of stuffing my mattress with something, that WILL yield something to me), but having it laid out like that, and having numbers crunched empirically... Priceless!
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Old 12-09-2012, 10:13 AM   #6
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Another recent article on the issue with two great charts:

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Real Rates and Gold
Adam Hamilton November 23, 2012 3089 Words

Early in gold’s secular bull, contrarian investors looked to real interest rates as one of this metal’s primary drivers. Eleven years ago when gold still languished under $300, mainstreamers scoffed at the notion that there would ever be sizable gold investment demand. But then, as now, negative real rates create strong incentives for bond investors to deploy significant fractions of their portfolios in this unique asset.

In the financial world, the word “real” simply means after inflation. It reflects capital’s actual purchasing power rather than its nominal, or face, value. And ultimately purchasing power is all that matters. Savers invest the hard-earned surplus fruits of their labors in order to increase their future purchasing power. They forgo consumption today in order to grow their capital’s utility to afford higher future consumption.

So in order to be successful, investors must earn returns exceeding inflation. As any country’s central bank grows its money supply, relatively more currency bids up the prices of relatively fewer goods and services. These money-driven general price increases are called inflation, as they result from an inflating money supply. Inflation insidiously erodes investors’ nominal returns, sapping their purchasing power.

For stock investors, inflation’s persistent threat is manageable. The annual returns earned in great stocks prudently bought when their prices were relatively low are usually well into the double digits. So it isn’t too hard to stay ahead of inflation in the stock markets. But for bond investors, inflation is a terrible threat. It vies with rising interest rates for the crown of being the single most destructive force to growing capital.

And it’s easy to understand why, bond yields are fixed and much lower than stock returns. If you invest in a bond that yields 5%, but general price levels are rising by 3% annually, the actual utility of your capital is only growing by 2% a year. Amazingly such paltry real returns are acceptable to most bond investors. They value perceived safety more than capital appreciation, so their expectations are low.

But sometimes real rates are driven into negative territory. Inflation exceeds bond yields, which means investing in bonds actually leaves investors poorer in real terms! Negative real rates aren’t natural, they only result from extreme central-bank meddling. When central banks artificially manipulate interest rates, which are the price of capital, too low, negative real rates result. They are the bane of bond investors.

If you can only earn 1% yields in bonds, but inflation is running 3%, your capital’s purchasing power is shrinking by 2% annually. Why even bother buying bonds at that point? When a supposedly safe asset is slowly destroying your capital, it’s time for prudent investors to move elsewhere. And that is where gold comes into play. Negative real rates have always created some of its most bullish conditions possible.

In normal times when bonds yield positive real returns, the primary criticism against gold is it has no yield. Why buy gold and earn nothing when bonds earn something? But once real rates are forced into negative territory, this argument vanishes. Zero returns are certainly superior to negative ones. But more importantly, the inflation associated with negative real rates ignites gold price gains far exceeding that inflation.

Inflation and negative real rates have always been inextricably linked. In fact, way back in July 2001 when I wrote my original essay in this series, I led off with a Fed official’s quote. He wrote, “The Fed’s attempts to stimulate the economy during the 1970s through what amounted to a policy of extremely low real interest rates led to steadily rising inflation that was finally checked at great cost during the 1980s.”

Talk about deja vu! Does the Fed attempting to stimulate the economy with a policy of extremely low real interest rates sound familiar? This exact thing has happened in spades since 2008’s stock panic! And one key result was very predictable, surging gold prices. When the Fed actively punishes savers for lending their precious surplus income, a growing fraction of them wisely flock to gold for protection.

This first chart looks at real rates and gold over the past decade or so, during gold’s secular bull. The black line is the baseline bond yield as measured by 1-year US Treasury bills, the nominal return. The white line shows the annual change in the US Consumer Price Index, the most widely accepted inflation gauge. When inflation is subtracted from nominal yields, the blue real-interest-rate line is the result.

This past decade hasn’t been kind to bond investors. The Fed’s easy-money policies forced real rates into negative territory for years at a time. It all started in 2001, when the Fed responded to a cyclical stock bear by slashing its benchmark interest rates. This put irresistible downward pressure on all bond yields. Interestingly after averaging just $272 in all of 2001, gold finally broke out above $325 in late 2002 as real rates first plunged deeply below zero.

These negative real rates were absolutely a key driver of this secular gold bull’s early advances. They nullified the standard gold criticism that it doesn’t pay a yield, attracting in growing legions of weary bond investors. As real rates remained negative into 2005, gold continued to relentlessly rally. After directly manipulating bond yields sharply lower, the Greenspan Fed didn’t effectively restore them until 2006.

And as you can see above, as real rates shot positive that year gold stalled out. It consolidated sideways for well over a year until the Fed started panicking again about the subprime-mortgage crisis. So once again it ramped up its printing presses and cut the key interest rates it directly controls. All bond yields followed, and real rates started plunging again. Gold surged to dramatic new bull highs thanks to this event.

Things had started to stabilize in early 2008, but then that once-in-a-century stock panic slammed into the markets with breathtaking fury. So the Fed frantically started slashing rates again, this time forcing them near zero under Bernanke. Gold once again started rallying rapidly and never looked back. Even when CPI inflation temporarily went negative, bond investors remained skeptical with nominal yields so low.

Gold’s utterly massive post-panic advance didn’t stall out itself until late 2011, when deeply negative real rates started climbing again on slackening inflation. But as real rates remained far from positive territory, gold never gave back much of its recent years’ big gains. With the bond markets yielding next to nothing, gold has remained a very attractive destination for capital. And I don’t expect this to end anytime soon.

Since real interest rates are the difference between nominal bond yields and inflation, let’s consider the coming years’ outlook for each in turn. It was right after the stock panic the Bernanke Fed made the unprecedented decision to slash its federal-funds rate to zero. This crushed the yields on bonds, as evidenced by the black 1y-Treasury-yield line above. They have been languishing near zero ever since.

So the only way bond yields are going to rise back up to normal levels that don’t penalize savers is when the Fed lifts its zero-rate siege. And it ain’t gonna happen anytime soon, by the Fed’s own adamant declaration. The Federal Reserve makes interest-rate decisions at its Federal Open Market Committee meetings, which are held eight times a year. The latest happened in late October, just a month ago.

In that recent meeting’s statement, the Fed wrote that it “currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.” Over and over again, Fed officials have said they want to keep nominal rates at “exceptionally low levels” until well after the US economy starts recovering. So currently the Fed is effectively pledging zero rates for several more years!

With the fruits of this anti-saver policy being dismally low yields, the inflation rate is almost irrelevant. Until the Fed tightens massively and pegs its own short-term rates back up to 2%+, a vast increase from here, negative real rates are guaranteed. Nevertheless, the degree of inflation experienced in the coming years will determine just how negative real rates will be. The lower they go, the more bullish for gold.

And that requires a look at the CPI, the definitive inflation gauge today. I only use it in my essays because it is widely accepted by economists and traders, although it certainly shouldn’t be. The CPI is riddled with problems, and had a major methodology change in 2006 to minimize the impact of price increases on the headline index. The true inflation rate is much higher than the watered-down CPI suggests.

Remember that inflation is a monetary phenomenon. As the Fed creates new dollars faster than the underlying economy is growing, relatively more chase relatively less goods and services. Inflation is the resulting bidding up of their prices. Therefore the true inflation rate is much closer to money-supply growth. As I discussed in depth in an essay a couple weeks ago, this is actually running between 8% to 10% annually!

The CPI’s 2% is wildly understated, as you can easily prove in your own life. If you track your expenses with software like Quicken, run some reports on what your costs of living were in 2008 compared to 2012. Nearly everything you and your family need to survive, from food to shelter to other expenses to insurance is seeing annual price increases much closer to 8% than 2%. Our cost of living is rising dramatically.

This reality isn’t reflected in the CPI for political reasons. The politicians in Washington employ the statisticians who compute the CPI, and they don’t want to see higher reported inflation. Higher inflation scares Americans, who get anxious and complain and vote out incumbents. It also hurts the financial markets, leading to the same political outcome. Most importantly it limits Washington’s crazy overspending.

Higher reported inflation would lead to higher interest rates, dramatically forcing up the ultra-low Treasury yields and hence multiplying Washington’s gigantic interest expense. Higher inflation rates also drive up cost-of-living adjustments on welfare programs, which further cut into the discretionary spending available for politicians’ pet projects. Thus no one wants to see reported CPI inflation rise significantly.

But this is a delicate balancing act. If the CPI is too drastically underreported compared to what traders and their families are actually experiencing, they will start to lose faith in this inflation benchmark. And at that point, inflation expectations will soar. The Fed fears nothing more, as Bernanke often states in his speeches. So in order to remain credible, the CPI has to continue rising on balance in the coming years.

Rising inflation coupled with flat bond yields near zero means real rates are going to continue trending deeper into negative territory. And that is fantastic news for gold. Every additional basis point real interest rates are driven below zero intensifies the pain for bond investors. So more and more prudently exit the poverty machine of bonds and park some capital in gold, which will easily outpace inflation.

This has always been the case, as the last major episode of negative real rates abundantly proved. Way back in May 2001 as real rates threatened to go negative again for the first time in decades, I formally recommended our subscribers buy physical gold coins when gold was near $264. I’ve recommended gold continuously ever since. And a key part of the initial reason, a huge contrarian call, was the looming negative real rates.

This next chart expands the time frame all the way back to 1970. In addition, the real gold price is shown as inflated by the CPI. Before the Fed spent the 2000s mostly panicking, we hadn’t seen an episode of continuous negative real rates since the 1970s. And gold’s mind-boggling bull market experienced back then is rightly the stuff of legends. Negative real rates drive gold investment demand like nothing else.

While gold is approaching similar real levels to what it saw in the late 1970s, the character of its advance this time around is radically milder. In its famous parabolic blowoff between November 1979 and January 1980, gold skyrocketed 128% higher in less than 11 weeks! It more than doubled in a matter of months as a popular speculative mania set in and mainstream investors rushed in droves to buy into that superspike.

The latest interim high in gold’s secular bull happened in August 2011, during the last Congressional debt-ceiling debate that led to the current fiscal-cliff threat. But instead of taking less than 3 months for its final 125% gain, that run took 31 months this time around. So despite gold’s real heights, so far it has advanced vastly slower than it did in the terminal days of its last secular bull several decades ago.

And gold’s ultimate peak in this secular bull once mainstream investors finally fall in love with this metal en masse ought to be far higher than the last one anyway. Why? The money supply has grown far faster than the global gold supply over the decades since. On average over the long term, mining adds only around 1% to the global gold supply annually. This naturally-constrained slow supply growth is why gold is history’s ultimate form of money.

In the 32 years since gold’s last secular bull peaked, 1% growth compounded annually yields a global gold supply just 37% larger than what was available for purchase back then. An aggressive 2% leads to 88% growth. But meanwhile the broad US money supply, MZM today, has ballooned from just $853b in January 1980 to $11,270b today! This is staggering 1222% monetary growth, which equates to a compound annual growth rate near 8.4%.

So while the world’s above-ground gold supply spent three decades growing on the order of 37% to 88% thanks to mining, the Fed has inflated the US dollar supply by 1222%. So the amount of dollars available to chase gold as it becomes more popular are vast beyond imagining compared to what was available at the apex of the last secular bull. An 8%+ annual money-supply growth rate dwarfs a 1%-to-2% gold one into inconsequentiality.

Today’s secular gold bull is therefore destined to peak at real levels multiples higher than what we saw back in early 1980. And just like in that last secular bull, negative real rates will be a major driver. The longer they stay negative, the more they will sour bond investors on getting poorer for lending their hard-earned surplus capital. As they migrate into gold, they will continue bidding up its price, attracting others.

And this virtuous circle of bond flight capital migrating into gold will be massively larger this time around, for another simple reason. Back in 1970 before real rates went negative and catapulted gold higher, nominal yields were running around 4% at worst. Today they are less than 0.2% for a 1y Treasury! Rising interest rates are far more dangerous to bond investors than inflation, and the risks today are staggering.

After bonds are issued at a fixed interest rate, they trade in the secondary markets. And supply and demand forces their yields in line with prevailing interest rates. So if you buy a bond for $1000 yielding 3%, but market rates rise to 6%, its market value will be cut in half. New buyers will only be willing to pay $500 for a bond yielding $30 per year, as that will bring its effective yield up to the prevailing 6% level.

So back in the 1970s when interest rates surged from 4% to 16%, bond investors were devastated. If they were in longer-term bonds and didn’t hold to maturity, they could have taken losses of up to 75% of their capital on rising rates. Meanwhile today the starting point for yields isn’t 4%, but 0.16%. So if they merely climb back up to 5% like they were before the stock panic, that is a 31x increase as opposed to only 4x in the 1970s!

The price risk on bonds today with interest rates near record lows is radically higher than it was in the 1970s during the last negative-real-rates episode. And a variety of market and fiscal events could easily drive bond yields way higher than 5% this time around too. So bond investors caught in a rising-rate environment, especially if it happens rapidly, could face losses defying belief. This makes gold far more attractive.

Not only is the Fed guaranteeing negative real rates for years to come, but its fast ramping of the money supply ensures even reported inflation is going to rise. And as real rates plunge more and more negative, the principal risk faced by bond investors with prevailing interest rates near record lows is unprecedented. Today’s negative-real-rate environment is far more bullish for gold than even the 1970s one proved to be.


The bottom line is negative real interest rates create the most bullish environment possible for gold. They force prudent bond investors to shift capital into gold to stay ahead of the ravages of monetary inflation. And since the Fed has crazily forced yields to record lows, today’s bond investors face the greatest risks for the biggest losses ever witnessed. Gold offers not only a refuge, but fantastic appreciation potential.

And these negative real rates are going to persist for years to come. The Fed has promised to keep its asinine anti-saver zero-rate policy in place “at least through mid-2015”. Meanwhile this central bank’s high monetary inflation rate is gradually forcing the CPI higher to maintain credibility among traders. And the longer real rates remain negative and the deeper they sink, the more bullish it is for gold investment demand.
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