Real Rates and Gold

Adam Hamilton    July 20, 2001    4708 Words


“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.” – Bharat Trehan, Federal Reserve Bank of San Francisco Weekly Letter, November 5, 1993


Recently a friend sent me a fascinating Federal Reserve study on real interest rates from which our opening quote is drawn.  It provides some ominous insights into the tremendously detrimental effects of low or negative real interest rates, which the study claims create a vicious circle of accelerating inflation.  Although discussing events of the 1970s and early 1980s, the report rings eerily familiar and could easily be describing the current ultra-high risk Greenspan Gambit the Fed has boldly embarked upon in 2001.


Real interest rates are once again becoming “really” interesting and are making the mainstream financial news more often.  Even economists on bubblevision paid to be perpetually bullish and always herd people into stocks are beginning to express concern about the current very low real rates of interest that Greenspan and gang have spawned.  Real interest rates have been blasted so far out of their normal range by the unprecedented aggressive Fed rate cuts of the first half of 2001 that everyone in the markets is sitting up and taking notice of this portentous anomaly.


Real interest rates are tremendously important and have vast and far-reaching effects that cascade through virtually all of the major global capital markets.  Changes in real interest rates are one of the most effective stimuli to spur investors to execute epic strategic portfolio changes and move extremely large amounts of capital into other investment types.  Understanding real interest rates and the potential impact of changes in these rates is incredibly important for all investors, whether their capital is deployed in stocks, bonds, or hard assets.  In this essay, we will drill down on real interest rates and their potential effects on gold.


Although somewhat cryptic sounding, real interest rates are actually quite easy to understand.


In order to grasp real interest rates, one must first build off the foundation of nominal interest rates.  Nominal interest rates can be defined as interest rates not adjusted for inflation.  They are the normal stated interest rates on the face of debt instruments.  If you buy a brand new US Treasury Bond, and the yield on the face of the instrument is 5%, then your nominal interest rate on the bond is 5%.  If you borrow money to buy a house, and you pay 8% per your mortgage contract, your nominal interest rate is 8%.  Nominal interest rates are what are quoted every day for innumerable financial instruments that pay some form of fixed return to their owners.  When interest rates are discussed casually, nominal interest rates are the subject of the discussions.


Real interest rates are simply the normal nominal interest rates LESS inflation.


As we all instinctively know, inflation is a bad thing.  Unfortunately, in this extraordinary age of deception in which we live, most people have been brainwashed into believing that rising prices cause inflation.  Watch any mainstream financial news program or read a newspaper and whenever inflation is discussed the implicit assumption is virtually always made that as long as consumer prices are not rising, then there is no inflation.  This mistaken notion is yet another fanciful component of the complex “New Era” mythology.


Historically and properly, inflation is truly defined as an increase in the money supply.  When central banks like the Federal Reserve throw discipline to the wind and create fiat currencies at rates exceeding the growth rate of their economies, inflation is the inevitable result.  Inflation is solely a monetary phenomenon caused by relatively more fiat dollars chasing relatively fewer goods and services in an economy.  Even Noah Webster’s massive benchmark dictionary defines inflation as an increasing money supply that CAUSES an increase in prices.  Rising general price levels are simply a symptom of excessive money supply growth, the actual inflation itself is perpetrated by central banks running printing presses.  For a much deeper discussion on inflation, please see our earlier essay “Exploding Inflation”.  And for a fascinating real-world example of inflation in cyberspace of all places, please see the intro to our essay “Deflating the Dow”.


While nominal interest rates are easy to discern, the rate of inflation is much more elusive to determine and infinitely more controversial.


Many contrarian analysts today are arriving at the conclusion that inflation should be measured in terms of money supply growth.  Since money supply expansion is the root cause of inflation, we are firmly entrenched in that camp and believe aggregate monetary growth is the best measure of the inflation rate.  For the US in the first six months of 2001, the narrow MZM money supply exploded at an 18.7% annualized rate and the broad M3 ballooned by 11.3% annualized.  For any students of history, fiat currencies, and what happens to nations and empires when monetary debasement reaches extremes, these amazing numbers should be utterly terrifying.


A more conservative measure of inflation is derived by taking the monetary growth rates and subtracting the growth rate of the economy to arrive at an inflation estimate.  Using the monetary growth rates with which Greenspan has vexed our great nation in the first half of 2001, the inflation rate is well into the teens since economic growth has been so anemic as measured by the official US Gross Domestic Product reports.  While we believe that money supply growth is the only honest measure of inflation, the idea would never fly amongst the legions of perma-bulls so we will play their game and use the worst and least reliable measure of “inflation”, the Consumer Price Index.


In concept, the CPI doesn’t sound too terribly bad.  It is supposed to be a basket of goods and services prices that are measured each month in order to detect price increases, the SYMPTOMS, not the cause, of inflation.  Unfortunately, the folks who maintain the CPI at the Bureau of Labor Statistics have cowered to political pressure in the 1990s and they have eviscerated the CPI of all its usefulness. 


The CPI is now heavily “hedonized”, meaning statisticians use mathematical wizardry to cancel out the effects of price increases.  For instance, if a computer rises in price, the BLS illuminati will declare that because the computer has more power than a 1990 model that therefore its price has really dropped because a unit of computing power is cheaper.  What a way to cook the books!  Imagine what you would think if your broker sent you a chart of a stock that was falling in price and losing money and he just ignored the real-world data and arbitrarily drew in his own lines and said, “I know you are losing money, but your stock is really rallying if you hedonize out the effects of the selling pressure.”  Taking good, clean real-world data and tactically filtering it to eliminate unwanted effects and provide a pre-determined outcome is intellectually dishonest and ludicrous.


As if hedonics are not enough of a headache, the CPI has been Balkanized to break out the costs most important to American consumers.  Food, energy, and some shelter costs are not included in the falsely so-called “core” inflation rate.  This also contributes to the sorry farce that the CPI has evolved into.  Anyone who has a family knows that the most important and largest living costs are shelter (mortgage or rent payments), food, and energy (both gasoline for vehicles and fuel for home climate control).  A CONSUMER price index that ignores these costs?  Lunacy.  The BLS is basically trying to convince the equity markets that without food, energy, or shelter there is minimal inflation in the United States.  This straw man is easy to knock down, however, as all anyone has to do is compare their bills for the things they need to live now with what they paid five years ago.  We are all but certain there is not a single American who is not paying more for most of the same staples now than they were five or ten years ago.


We discussed the CPI in much more detail in our earlier essay “Lies, Damn Lies, and CPI”.  Although we zealously believe the Consumer Price Index is a bad joke at best and an outright fraud at worst, it is still unfortunately the most widely accepted definition of inflation.  Everyone from the talking heads on bubblevision to government economists to the garden-variety perma-bulls believes the heavily gutted and engineered CPI is THE definition of inflation.  In order to be as conservative as possible, we will use the CPI in this essay as our inflation variable, even though we don’t like it one bit and think it vastly understates true inflation in the United States.


With nominal interest rates in the bag, and the CPI used as an inflation measure, it becomes really easy to calculate real interest rates.  We used the constant maturity one year US Treasury Bill rate of return as our nominal interest rate, as it is widely accepted as the ultimate “risk-free” rate of return in the financial markets.  We grudgingly used the year-over-year change in the non-seasonally adjusted CPI as our inflation rate proxy.  The one year T-bill rate less the one year change in the CPI equals our real rate of interest for this essay.


Before we jump into the graphs and data, one further discussion is in order, the effects of real interest rate changes on creditors and debtors.


In a capitalist economy, there are folks who are able to accumulate more capital than they need through saving.  Some of these savers choose to lend their capital out to others who need more capital than they have, the debtors.  The savers and debtors meet through financial intermediaries like banks that enable surplus capital to be redeployed in ventures that presumably need that capital to build productive businesses.  Inflation and real interest rates affect creditors and debtors in very different ways.


From a debtor’s standpoint, inflation can be a positive.  As the money supply grows, each dollar becomes worth less and less in terms of the goods or services it can buy.  The debtor can count on inflation to erode purchasing power over the life of a loan and have the ultimate effect of decreasing their debt load in real terms.  Debtors love this effect of inflation.  Sadly, with Americans generally becoming a nation of sorry debtors, it is not surprising that politicians and leaders are almost all pro-inflation since debtors make up most of their constituency.


Creditors, on the other hand, count inflation as their vile nemesis and mortal enemy.  Over the life of a loan that a creditor grants to a debtor, inflation weakens the dollar and causes the creditor to be repaid in dollars worth less than they were when the capital transaction was consummated.  Inflation expropriates or robs real wealth from creditors.  As inflation rises, the real rate of return on the capital creditors have painstakingly saved and then lent out drops.  A point arrives when a creditor decides a paltry inflation-adjusted return is just too low to bear the risk of default inherent in lending their surplus capital.  As real rates of return rapidly approach zero in our current economy thanks to the Greenspan Gambit to bail out the stock speculators, more and more creditors will decide enough is enough and pull their capital out of the debt markets.  For a much deeper discussion of the bond and debt markets, please see our essay “Revolt of the Long Bond”.


As creditors bail out of debt instruments in response to plunging real rates of return, much of their capital migrates to other destinations.  Greenspan is probably staying up late at night drenched in a cold sweat praying that the bond creditors will move money back into the battered US equity markets as real rates of return on debt instruments implode.  Greenspan seems to believe that the Fed now has a mission of supporting the US equity markets in order to keep consumer confidence high, to keep consumers on their debt-financed spending binge, and to prevent something awful in the US financial markets.  With the incredibly overvalued and dangerous US equity markets (please see our essay “US Equities: A Strategic Perspective”), odds are that the ultra savvy debt market players will not migrate into stocks en masse as the bulls fervently hope.


Historically, when real rates of return approach zero or slice through to negative levels, a significant amount of capital flows into the ultimate financial asset, gold.  Gold is the ancient metal of kings and is a unique monetary asset in that it has intrinsic value in and of itself that is recognized in every corner of the world.  It does not simply represent someone else’s promise to pay like fiat currencies.  Through six millennia of currency debasement, the rise and fall of a myriad of nations and empires, and the extinction of every fiat currency that ever existed prior to our latest massive world wide fiat experiment of the last half century, gold has steadfastly maintained its purchasing power and protected scarce capital.  It is the ultimate financial safe haven for refuge when the storms of speculative manias and fiat currency excesses are hammering the world financial oceans.


Our mission in this essay is to examine four decades of real rates of return and the gold price in order to try and divine the probable gold response to Greenspan’s latest frantic effort to push real rates below zero and smoke out bond investors.


All graphs in this essay use monthly data.  Once again, we defined the real interest rate as the one year Treasury Bill rate minus the year-over-year change in the Consumer Price Index.  Real rates are drawn in blue if positive and red if negative and slaved to the left axis.  The gold data used is the monthly average closing spot price of the metal and is tied to the right axis.  We begin with a macro strategic perspective showing real rates and gold from 1960 to June 2001.



From a broad strategic perspective, the first thing that immediately leaps out of this graph is that the greatest gold bull market in modern history roared to the heavens during the surreal period of negative real interest rates that marred the 1970s.  Note that the gold market left the launching pad soon after real interest rates made an initial spike below zero, marked by the white arrows above.  The gold rally did not end until the Federal Reserve under Paul Volker frantically raised interest rates to third world heights in the early 1980s to combat double-digit inflation in the United States that arose as a result of undisciplined fiat currency growth in the 1970s.  Volker had to administer bitter medicine to atone for past Federal Reserve sins.


The most important nugget of information to glean from this strategic initial graph is to realize that gold has rallied dramatically when real interest rates were pushed negative by the Federal Reserve and gold has fallen from grace when real interest rates remained high enough to provide a fair rate of return for debt-market investors (creditors).  Although correlation does not necessarily imply causation, a very strong case can be made that large amounts of money are poured into gold when plummeting real rates of return make traditional conservative debt investments a losing proposition.  Elite bond players pack their bags and move their capital elsewhere when central banks attempt to dishonestly expropriate their wealth through excessive inflation.


Drilling a little deeper, we zoom into the same dataset for the 1970s. Since the culmination of 1970s financial messes occurred in the early 1980s, we extended this graph to cover the period of time from January 1970 to December 1982.



Zooming in, the relationship between gold prices and real interest rates becomes much more apparent.  Note that gold started rising slowly in 1971 after the first episode of negative real interest rates.  Soon after, in August of 1971, President Richard Nixon reluctantly admitted the US dollar was worthless when the United States of America officially defaulted on its gold standard dollar obligations and refused to honor its promises to pay gold on demand to foreign holders of US dollars.


At point “1” in the graph, real interest rates again knifed through zero like a razor-sharp machete through a withered jungle vine, and gold recommenced its rally at a much steeper slope almost immediately (point “2”).  Dismal real rates of return pushed investors into the hard assets to preserve their scarce capital.


In 1974, private gold ownership once again became legal for US citizens.  Socialist thug Franklin Delano Roosevelt had unconstitutionally stolen the private gold of American citizens in 1933 soon after he was inaugurated, breaking all his promises he campaigned upon regarding maintaining the internal gold standard for the US dollar and not devaluing the currency relative to gold.  Following Roosevelt’s reneging of all his campaign promises regarding gold and money, gold ownership was outlawed for decades until 1974, when once again US citizens were granted the “privilege” of owning what central banks call a “barbaric relic”.


At point “3” in the mid-1970s, gold made an interim top when the real rates of return stabilized and began trending up.  Interestingly, the gold downtrend continued as long as the real interest rates kept recovering.  At point “4”, gold bottomed at the same time real interest rates once again peaked.  This time, upon realizing that the Federal Reserve’s hollow promises of stable inflation were a hoax and real rates were falling towards zero once again, investors finally became tired of losing money in debt instruments and stampeded into gold in ever-increasing numbers, ultimately pushing it to stratospheric bubble blow-off heights in 1980.  Gold entered its terminal stage speculative mania at point “5”, when real rates once again sunk below zero adding further fuel to the inflationary fire and panic to get money into a safe destination as debt market real yields remained destructive to capital.


By point “6”, gold had made a secondary top after the crash from its preceding mania top which immediately began to deflate as the Fed under Volker aggressively raised interest rates to astounding heights in an attempt to push real rates of return positive and tame inflation.  The rally in real rates and the slump in gold continued unabated until point “7”.  Once again, at point “7” gold kicked off a large rally right when real rates of return began to fall south once again.


The inverse correlation between real interest rates and gold as well as the near identical turning points for the two data series are quite provocative.  Using this data alone, it certainly appears that real interest rates have a strong effect on the price of gold.  When real rates of return fall to near zero or below, capital flees credit instruments that begin to actually destroy real wealth and some seeks refuge in the ultimate safe asset, gold.


If Greenspan and crew manage to inflate us into a 1970s type scenario with dizzyingly rapid money supply growth, raging inflation, and negative real interest rates, the probability is quite high in light of this historical data that gold will kick off a major multi-year rally as savers of capital buy gold to preserve and enhance their wealth and prevent the ongoing promiscuous debasement of the US dollar by the Fed from destroying their scarce and valuable real capital.


In contrast to the 1970s, the 1980s witnessed generally very high real rates of return and a downtrend in gold.



After Volker’s shock therapy, money supply growth abated and inflation as measured by the CPI began to fall back in line with more acceptable levels.  Real rates of return on debt instruments reached stellar heights, approaching 8% several times. Gold stumbled from its super high levels beginning when real rates bottomed and began rocketing northward under Volker, marked by the lower white arrow in the graph.


Although there were no subsequent episodes of negative real rates in the 1980s, it is very instructive to note the inherent symmetry between gold and real interest rates.  The top arrow above marks the beginning of a period of many years where gold traded almost exactly opposed to real interest rate moves.  When real interest rates trended up, gold would fall.  When real interest rates trended down, gold would rally.  The general inverted relationship between gold and real rates that was well established in the 1970s continued through the 1980s.


The 1980s are an important period in modern gold market history for another reason as well.  In the 1990s under Clinton and Rubin, increasingly more evidence is being uncovered that indicates that there has been a concerted official sector effort to stealthily manage the gold price in an attempt to protect overvalued and fragile fiat currencies and equity markets.  Gold traders began to note odd activity in the gold market in late 1994 and early 1995, when gold quit acting on supply and demand fundamentals and central bank sales and leasing ballooned dramatically.  Studying gold in the 1980s is really important because it provides a period of time when gold traded much more freely and central banks were nowhere near as manipulative or aggressive in intervening in markets as they have become in our unfortunate neo-Keynesian socialist era today.


And that brings us to the 1990s, the decade of the enormous NASDAQ bubble, perpetual financial crises blooming around different parts of the globe, and the period of time when central banks began to aggressively artificially augment world gold supply through carefully timed sales of their huge gold hoards. Please note that in the following graph both the left and right axes have been shrunk to better fit the data, and it encompasses the period of time from January 1990 to June 2001.



The 1990s witnessed many interesting developments in both real rates and gold.  In the early 1990s, real rates plunged to zero for the first time in over a decade.  Not surprisingly in light of the past data, gold had its largest and most dramatic rally of the decade at precisely this time when real interest rates were dismal.  This rally is marked by the first white arrow.


For the rest of the decade, real interest rates remained relatively stable around 2.5%-3.0%, and gold began its long swoon after briefly touching $400 in early 1996.  The only major price spike in this long bear trend occurred in September 1999 when European central banks announced they were capping gold sales in following years in order to stop decimating the gold market.  This rapid and ethereal Washington Agreement rally was mostly news driven and had nothing to do with real interest rates, however, and central bank gold continued to covertly ooze out into the markets in large enough quantities to more than make up the annual mined supply/total world demand deficit and drive the gold price lower once again.


This graph also finally brings us to the most provocative data point of the whole essay.  Marked by the second white arrow, real interest rates have once again hemorrhaged dramatically in the wake of the Greenspan Gambit series of interest rate cuts in 2001.  If you scroll back up and scan the big strategic overview graph, it becomes readily apparent that this precipitous decline in real interest rates in the first half of this year is the steepest slide from normal positive levels since the mid-1970s.  The 1970s slide in real rates, as we discussed above, marked the beginning of the biggest gold bull in modern history.  It was truly spectacular and legendary profits were won.  Are we seeing a similar setup now?


The tendency of investors to flee out of debt instruments and flood into gold when real interest rates become destructive for capital leaves Greenspan in an extremely dangerous predicament. 


With unrelenting stock market weakness, the Wall Street establishment continues to wail and howl for more interest rate cuts to boost the equity market.  Lower interest rates make stocks more attractive by reducing the competition for capital coming from the debt markets and also by supporting higher valuations through lower required returns in net present value calculations.  Greenspan is also well aware that the US consumers have record exposure to stocks, are heavily indebted, and their confidence is closely tied to the fortunes of the US stock markets.  If the Dow falls decisively below 10,000 and the NASDAQ smashes through its April lows, both of which we anticipate, Greenspan realizes that US consumers will become frightened and may greatly rein in spending.


In our modern fragile debt-based inflationary US economy, even a small move to spend less by consumers, who account for 2/3 of the total economy, would devastate the US corporate sector and virtually ensure a dramatic downdraft in the stock markets as earnings plummeted and still dangerously high valuations deflated as there were scarcer and scarcer hard profits to support them.


A vicious circle could be initiated by the next big stock market down-leg.  American investors and consumers will witness it and become frightened, so they will reduce their spending.  Corporations will make less money as consumer spending tapers off, so they will fire more of their people and report lower earnings.  Additional layoffs will further frighten the US consumer, who will spend even less and begin to pay down debt when possible, further crimping the US economy.  The stock markets will then sell off even further in response to plunging earnings and a negative, self-reinforcing cycle will ensue.  We are convinced Greenspan is deathly afraid of this alternative and will do everything in his power to prop up the US equity markets.


On the other hand, in order to throw the bleeding equity speculators a bone, Greenspan has to keep cutting interest rates.  But, if he cuts rates further and the CPI doesn’t fall, real rates officially go negative for the first time since the early 1980s, scaring the heck out of bond market investors and probably igniting a new bull market in gold.  As the Federal Reserve is widely believed to be involved in the hooliganism in the gold market since 1995, they are obviously not excited about seeing a rising gold price.  As the gold price rises, it signals a vote of no-confidence in the fiat dollar and the policies of the US Federal Reserve to the rest of the world, not a happy outcome for the fragile US equity markets and horribly debased US dollar.


As a no less menacing third alternative, real rates can fall negative even if the Fed stops easing right now if the CPI rises in response to the outrageous fiat money supply growth of 2001, kicking off the negative real rate scenario even without further Fed largesse.


So what is a central banker to do?  Stop lowering interest rates and risk a huge implosion of the fragile US equity markets or keep lowering interest rates and push real rates negative risking a huge gold rally and eviscerating the dollar?  Greenspan faces a Faustian dilemma.  Either alternative seems to be highly hazardous for general equity investors and potentially very lucrative for gold investors.


With money supply growth exploding, real interest rates once again approaching zero as in the 1970s, and the US equity markets experiencing the not-too-pleasant consequences of a speculative mania bubble burst and bust, there is a high probability gold is poised for a dramatic rally in the coming years.  Virtually every conceivable macro-economic, financial, and supply/demand factor is lining up perfectly for a spectacular gold rally. 


Negative real interest rates may well prove to be the straw that breaks the camel’s back of the official US and European efforts to cap the price of gold.  We will be monitoring real rates closely in 2001 and 2002 as the Fed continues its desperate last-ditch attempt to re-inflate the bursting American equity bubble.  As the hard-earned capital of bond investors is wrongfully expropriated through inflation and negative real interest rates, we fully expect a significant portion of that capital to make a mass exodus to the rock-solid financial refuge of gold.


Adam Hamilton, CPA     July 20, 2001     Subscribe