by Adam Hamilton
It's been a tough year for gold investors. Instead of soaring during the great fear and uncertainty of the global financial panic as most gold investors expected, gold got caught up in the selling. Thus it is down 7.3% year-to-date. This is far-better performance than virtually everything else, especially the S&P 500's 40.7% YTD loss. Nevertheless, the lack of a flight to gold in such dire conditions remains disappointing.
Why didn't gold rally? Capital fleeing out of the imploding bond and stock markets flooded into US Treasuries at staggering rates. While Treasuries weren't yielding much, at least they sheltered capital from the surrounding universal panic selling. Before taking refuge in Treasuries, foreign investors first had to buy US dollars. This frenzied dynamic drove a monster dollar rally which hammered gold futures.
Since gold has been the financial-panic asset of choice for centuries, its lackluster trading action during the last couple months has really shaken gold investors' confidence. While physical-coin demand has been very high from small investors, big investors did not rush to buy gold as stock-market fear soared to unprecedented sustained levels. This is leading to questions about this gold bull's ongoing viability.
During times like these when the technical action and sentiment feel terrible, I find it useful to return to the core fundamentals. I started recommending physical gold coins to our subscribers back in May 2001 when gold traded in the $260s. In the 7+ years since, gold has seen plenty of good and bad spells. Yet one major fundamental driver remained steadfastly bullish throughout this bull, real interest rates.
Real rates are the returns realized by bond investors after inflation is subtracted out. If you earn 5% in Treasuries, and inflation is running 3%, then you earn a 2% real return. Much of the 1.05x growth in your nominal capital is eroded by the relentless loss of purchasing power in the dollar. What you could buy last year for $1.00 now costs $1.03, so in terms of real goods and services you aren't advancing as fast.
Normally real rates are positive. For putting their hard-earned capital at risk, debt investors deserve to earn a real purchasing-power return after inflation for their efforts. Even though they don't accept much risk compared to stock investors, they still need to be fairly compensated for this risk. If they are not, they will invest less over the long term because it is pointless to risk scarce capital for a guaranteed loss.
Would you loan money to anyone if you knew you would take a real loss for doing so? Not if you are rational. When nominal interest rates are forced so low by central banks that real returns plunge negative, debt investing becomes a losing proposition. In such a hostile environment, debt investors gradually turn to gold. While bonds guarantee them a real loss, gold will at least keep pace with inflation to preserve the purchasing power of their capital.
To understand the interaction between real rates and gold, you really have to take the long view. Since it takes years for investors to perceive the impact of inflation and change their behavior accordingly, gold doesn't react overnight. But eventually react it does, and this is very clear over a long-enough time slice. The longer real bond returns are poor or negative, the more capital gradually takes refuge in gold.
Interestingly I wrote my first essay in this series back in July 2001 when gold traded in the $260s. Back then real rates had yet to go negative but the Fed was hellbent on driving them there. At that time, we only had the example of the 1970s to consider. But now, the lion's share of a decade later, the real-rates-and-gold comparison is vividly apparent in the 2000s as well. Just as expected, when central banks attack debt investors they gradually forsake losing bonds and migrate into gold.
While researching real rates, I try to use the most-conservative-possible measures. While this really understates the bullish case for gold, it is much easier for mainstream investors to accept and very easy for contrarians to defend. Since most interest rates are still driven by the free markets despite all of Washington's incessant socialist meddling, the inflation measure used is where conservatism comes into play.
Wall Street believes the US government's Consumer Price Index is an accurate measure of inflation. Everyone accepts the CPI as gospel, so I've always used it in this research thread. Since inflation is truly defined as monetary growth, the growth rates in the money supplies are a far-superior measure. With the Fed running its printing presses like there is no tomorrow, relatively more money is chasing relatively less goods and services which drives up nominal prices.
Over the past year, the broad MZM money supply in the US has grown by 9.9%! This is much closer to true inflation than the CPI's modest 3.7% gain. For a variety of reasons including inflation-indexed welfare payments as well as inflationary perceptions' impact on the financial markets, the government statisticians intentionally lowball the CPI via mathematical wizardry. It is really a garbage indicator, but to most market participants the CPI is inflation. So I use it to be conservative, which really understates the case for gold.
To compute real rates, you simply take the nominal rate of return and subtract annual inflation growth. The purest and most-conservative interest rate to use is the yield on the 1-year US Treasury Bill. All over the world, short-term US Treasuries are considered "risk-free" investments that are the foundation for interest rates. Since Washington can create infinite fiat US dollars out of thin air to pay Treasury investors, there is really no risk of default unless a rebellion or invasion takes out Washington.
Also on real-rates analysis, synching up the time periods is crucial. Since interest rates are typically thought of in annual terms, a 1-year span is ideal. And 1y T-bill yields match up perfectly with the year-over-year change in the CPI. So 1y T-bill yields minus the YoY CPI growth equals real interest rates. Comparing these to gold over strategic time spans is very interesting.
In these charts, 1y T-bill yields are rendered in black. The YoY CPI change, which is only published once a month and hence looks stair-steppy, is drawn in white. The difference between this nominal yield and inflation is the real rate shown in blue. Finally gold is superimposed over the top of all this interest-rate data in red. As you'll see, low and negative real rates are very bullish for gold.
It always strikes me as ironic. Manipulation theorists spend endless hours railing about perceived manipulation in tiny subsets of the financial markets. But the biggest manipulation of all is out in the open. Like the old Soviet Politburo, the unconstitutional Federal Reserve meets in secret to set the price for money traded among banks. If the Fed was abolished as it should be, and overnight rates operated in a truly free market, the entire financial system would be infinitely more sound than it is today.
In real-rates analysis, we have to start with nominal interest rates. And the shorter the term of a debt instrument, the more the Fed's heavy-handed manipulation influences its yields. 3m Treasuries usually trade in lockstep with the Fed's target overnight bank rate (fed funds), while 30y Treasuries largely ignore it. Since 1y Treasuries are relatively short on this time scale, they are heavily influenced by Fed manipulations.
The black 1y Treasury yield line above looks very similar to the Fed's fed-funds-rate target. Since the Fed dominates the short end of the yield curve, it also dominates real rates. When the Fed drives its own interest rates to artificially-low levels, 1y T-bill yields follow. And if these nominal returns fall below the rate of headline inflation growth, all of a sudden debt investors are losing purchasing power by investing.
Back in 2000, Treasury yields were reasonable near 6%. Investors earned a fair return on their precious capital while debtors paid a fair rate to borrow it, above inflation on both fronts. But in early 2001, the healthy post-tech-stock-bubble bear spooked Alan Greenspan into sowing the seeds for today's calamity. To try and reinflate a stock bubble, the Fed drove nominal rates down to inflation rates so real rates fell to zero.
Note above that gold was languishing, consolidating after a multi-decade bear, until real rates fell decisively under 1%. And gold really didn't start accelerating until real rates went negative in 2002. Negative real rates drive investment demand for gold because bonds become unattractive. Investor preference gradually switches to gold, which will keep pace with inflation, instead of falling behind in under-yielding bonds.
Of course the Fed's monetary inflation never goes where the Fed wants it to. In trying to reinflate the stock markets, Greenspan instead ignited the housing bubble. Its terrible aftermath is apparent today. Never learning any lessons from history, the Fed is doing the same thing today that it did in the early 2000s. It just forced nominal rates down near 1% again to attempt to reinflate the housing bubble. Of course this new monetary inflation will go elsewhere to.
Between 2001 and 2006, with real rates at +1% or lower, gold thrived. It wasn't until real rates decisively headed over 1% again in mid-2006 that gold finally stopped advancing to consolidate. But as soon as the Fed panicked again in late 2007 and started slashing rates, real rates plummeted. Not surprisingly, gold simultaneously soared. More and more bond investors grew discouraged by the Fed's attack on them and bought gold.
Now realize there are many short-term forces acting on gold, such as the US dollar's behavior, general commodities trends, and overall financial-market sentiment. So there are many short-term places in this chart where gold and real rates are not tightly correlated. But if you filter out technical noise and examine this decade as a whole, it is crystal clear that gold has been very strong during a time of low and negative real rates. They spark big gold investment demand.
In late 2007 real rates plunged negative again as Ben Bernanke failed to learn the lessons from Alan Greenspan's disastrous easy-money inflationary orgy. By early 2008 they were -2%, the lowest levels seen in decades. Naturally gold was rocketing higher and headed above $1000 by March. And while gold did get caught up in the brutal commodities correction and global stock panic since, it remains near nice high levels in the context of its secular bull.
And check out real rates in the last 6 months or so. They have been -2% at best, falling to under -3% at times to their lowest levels since summer 1980! This is incredibly bullish for gold. Once the stock panic fades and the dollar-buying frenzy abates, fundamentals will again drive gold. And a negative-real-rate monetary environment hostile to bond investors is the most-bullish-possible environment for gold.
History is very clear in illustrating this fact, which we'll get to shortly here. But first consider the likely future course for real rates. CPI inflation growth is in a clear uptrend as rendered above. While prices for many things plunged during the panic of October and November 2008, prices will quickly stabilize as fear evaporates. So odds are this CPI uptrend will continue. With the Fed's incredible monetary growth, 10% in MZM compared to 0% growth in the US economy, higher general prices are absolutely inevitable.
And if CPI inflation remains at 4%+, heck even 3%+, real rates will stay negative. Failure is an important part of capitalism as it moves assets from incompetent managers to competent managers to keep the economy fresh and vibrant. But for some reason, those traitorous scum in Washington have decided no one should fail. They are hellbent on keeping interest rates artificially low forever if necessary so failed companies and managers can sit on and lock up stagnating assets. Karl Marx would be very proud.
Imagine what would happen if the Fed actually had the courage to quadruple interest rates to make the bond markets mutually beneficial to both investors and debtors again. Overextended debtors would actually fail! Oh the horror! Until nominal rates get up to the 4%+ range again, real rates will remain negative. And I can't see any way our cowardly Fed can raise rates substantially for a long time to come.
With a brutally negative real-rate environment here now and likely to persist for years, the monetary case for gold is exceedingly bullish. If bond investors can't earn a real return after inflation for the risks they take, they will be much better off holding gold. Sure, it doesn't pay a yield. But bonds really don't pay much today either. And unlike bond yields, gold will rise to keep pace with monetary inflation. Investors' purchasing power will be preserved.
All these monetary truths are readily apparent now, proved again in this past decade. But in mid-2001 when I started this thread of research, all we had to rely upon was history. Looking at gold and real rates since 1970 is fascinating. This chart is similar to the prior one except the gold price is adjusted for CPI inflation. Negative real rates helped drive the famous 1970s gold bull, which was far larger than today's so far.
Once again, there are a myriad of short-term factors that affect the gold price. So if you look closely, you can find short-term exceptions to the negative-real-rates-are-great-for-gold rule. But if you carefully consider this chart as a whole, the strategic implications of negative real rates become very apparent. In a secular sense gold does best when real rates are low or negative, and worst when they are healthy.
The 1970s was a time of inflation exceeding the nominal returns available on bonds. So debt investors, acting totally rationally, gradually shifted capital into gold. These investors drove a strong gold bull that speculators ultimately flooded into at the very end, igniting a legendary gold bubble. While the monthly data in this chart doesn't show the daily high, in today's 2008 dollars gold approached $2400 an ounce in January 1980! Today's gold bull isn't even close to seeing a similar blowoff top yet.
That 1970s gold bull only ended when Paul Volcker courageously hiked short-term interest rates dramatically until real rates shot positive to healthy levels again. With excellent 4% to 8% real returns available in bonds, investment demand for gold collapsed. And it didn't reignite again until decades later when real rates finally threatened to once more plunge decisively negative.
By foolishly deciding to bail out speculators in the housing bubble, including highly-leveraged banks and highly-leveraged house "owners", the Fed has trapped itself. Interest rates are way too low, they do not offer realistic returns for bond investors. Yet if the Fed raises rates to more rational levels, the speculators it is trying to bail out are going to fail. While healthy over the long term, this is apparently unacceptable politically.
As long as the Fed strong-arms nominal rates to levels under headline inflation, real rates are going to remain negative. Instead of sitting in bonds and losing real purchasing power year after year, increasing numbers of bond investors are going to park capital in gold to protect it from all this monetary inflation. Even though gold doesn't pay a yield, as long as it merely paces inflation it is a much better investment than bonds lagging behind inflation.
This argument certainly isn't new today. Back in 2001, the coming negative real rates were one of the main fundamental reasons I recommended our subscribers buy physical gold coins for core long-term investments. When the price of money isn't set by the free markets, when it isn't mutually beneficial and robs from investors to subsidize debtors, investors gradually pull out of the debt markets.
In July 2001 I opened my first essay in this series with a 1993 quotation from a Federal Reserve official. He said, "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." Sounds like today, no? Bernanke is doing the same thing done in the 1970s, and his endless easy money will ultimately lead to the same result, massive inflation.
Of course gold is the ultimate asset in highly inflationary times. And the unfathomable quantity of fiat-paper dollars the Fed is creating out of thin air to force-feed into the financial system these days is going to eventually manifest itself in tremendous inflation. This will drive great investment demand in gold and lead to gold's gains not only pacing inflation, but far exceeding it as more and more investors buy.
Gold didn't look great in the last few months, I agree. But don't let technical and sentiment anomalies cloud your perceptions of secular fundamental realities. Today's negative-real-rate environment courtesy of the Fed is the most-bullish-possible monetary environment for gold. Thus at Zeal we have been adding gold and gold-stock positions lately despite all the carnage. Contrarians buy when no one else wants to.
If you are wondering what to do with your capital after weathering the worst of the stock panic, the gold realm is a great place to put a sizeable chunk of it. I don't know of any more-bullish asset class in today's environment. I am more excited about gold today than I was in early 2001 before it quadrupled. To learn about and navigate these treacherous markets, and thrive as this panic abates, subscribe today to our acclaimed monthly newsletter.
The bottom line is negative real rates are one of gold's most powerful fundamental drivers. And thanks to the Fed refusing to let housing speculators fail as they should, negative real rates are going to persist for a long time to come. Maybe years. But bond investors are not dumb. They won't invest for long in an environment where their capital is guaranteed to lose real purchasing power. Some will migrate into gold.
Negative real rates were the monetary foundation of the biggest secular gold bulls in modern history, the 1970s and the 2000s. And just as it took radically high 6%+ real rates to end that 1970s gold bull, this bull isn't likely to end until we see sustained hugely positive real rates as well. In the meantime, gold will continue to thrive on balance despite big pullbacks from time to time driven by capricious sentiment.
Da Man
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