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.
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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.
