“For the first time since 2008, in our view, the investment environment for gold is deteriorating, as economic recovery, rising interest rates, and still benign Western inflation (for now) will likely leave some investors rethinking their cumulative $240 billion investment in gold over the past four years.”– Nomura Bank report, March 7, 2013
Mainstream bank analysts have among the worst records for predicting the future price of gold. We recently charted their predictions, which show just how consistently wrong they've been. In fact, their poor track record dates back to the 1970s – check out comment #11, which we dug up from 1976.
Nomura isn't the only bank making these kinds of claims. Goldman Sachs, Credit Suisse, Société Générale, and Citi have all stated that they expect interest rates to rise soon, and that when they do the gold bull market will be over.
On the surface, this makes sense. The attractiveness of holding a shiny metal that sits in a storage facility diminishes when you can earn interest from investments that benefit when rates rise.
But these analysts are overlooking an obvious factor in the relationship between interest rates and gold. That's the basis of our second article examining the ongoing catalysts for a rising gold price.
The Critical Number for Gold
As we examined last month, runaway debt and money-printing schemes will eventually lead to price inflation. This remains a core reason to maintain significant exposure to precious metals. However, there's one indicator that clearly signals that we not only remain in a bull market, but that we can expect gold prices to continue to rise. And it's one that mainstream analysts consistently overlook.
That indicator is negative real interest rates.
The real interest rate is simply the nominal rate minus inflation. For example, if you earn 4% on an interest-bearing investment and inflation is 2%, your real return is +2%. Conversely, if your investment earns 0.5% but inflation is 2%, your real return is -1.5%.
This calculation is the same regardless of how high either rate may be: a 15% interest rate and 13% inflation still nets you 2%. This is why rising interest rates are not necessarily negative for gold; if inflation is rising faster than rates, the real rate is still negative. And it's this relationship that determines what the gold price ultimately does.
This is important because it's likely you will use some of your metal to offset a rise in your cost of living, perhaps a significant one. If we get high inflation and prices rise, say, 50% over a two-year period, you could sell a portion of your gold and silver holdings to pay for the increase in your monthly expenses, completely nullifying the impact that inflation would have on your budget. And if you don't “spend” any of your gold, your heirs likely will.
We've developed a by-the-numbers way of determining the status of a gold bull market. As you'll see, this measure has held true throughout history, and is one that tells us the current gold bull run is far from over.
What History Tells Us
The chart below depicts the real interest rate by extracting annualized inflation from the 10-year Treasury nominal rate. Gray highlighted areas are the periods when the real interest rate was below zero, and as you can see, this is when gold has performed well.
The gold price climbs when real interest rates are low or falling, while high or rising real rates negatively impact it. This pattern was true in the 1970s, and it's true today.
You'll notice that the real rate recently ticked above zero. But a “zero” real rate is not the critical number for gold. A closer study shows the specific number for real rates that seems to have the most impact on the metal.
Take a look at how gold performs when real rates are at 2% or below.
So while real rates have ticked up and are now a smidgen above zero, history tells us that gold does well up until the real rate exceeds 2%.
The reason for this phenomenon is straightforward. When real interest rates are at or below zero, cash or debt instruments (like bonds) cease being effective because the return is lower than inflation. In these cases, the investment is actually losing purchasing power – regardless of what the investment pays. An investor's interest thus shifts to assets that offer returns above inflation… or at least a vehicle where money doesn't lose value. Negative real interest rates essentially incentivize capital to move into gold.
Politicians in the US, EU, Japan, and a host of other countries are keeping interest rates low, which, in spite of a low CPI, keeps real rates near zero. This makes cash and Treasuries continued guaranteed losers. Over the long-term, investors maintain purchasing power better with gold than with cash and interest-bearing instruments in this kind of environment.
Here's another way to verify this trend. As the following chart shows, from January 1970 through January 1980 gold returned a total of 1,832.6%. This is much higher than inflation during that decade, which totaled 105.8%.
Further supporting this thesis is the fact that when real rates are positive, gold has not performed well. You can see this in the following chart of when real interest rates were higher than inflation.
The gold price fluctuated between $300 and $500 for the twenty-year period when rates were positive. By the way, this is a strong reminder that bull markets don't last forever – even golden ones – and that at some point we'll need to sell to lock in a profit.
So if history demonstrates that gold does well during a negative-rate environment and poorly during positive periods, the natural question becomes…
How Much Longer Will Negative Real Rates Last?
As of last month, the Federal Reserve owns more than 40% of all Treasuries with a maturity greater than five years. With the balance sheet of many major countries equally bloated with paper money, this global unwinding process will be difficult to time, messy to carry out, and punishing to our standard of living.
As John Hathaway, portfolio manager of the Tocqueville Gold Fund, recently stated:
What will happen to long term interest rates when the Fed is no longer buying the lion's share of Treasury issuance? At stake is the economy, employment, and asset valuation to mention a few possibilities for collateral damage. Even though Treasury debt outstanding has tripled since 1998, the sum total of all interest paid by the Federal government on that debt has barely budged. A return to competitive real interest rates seems highly difficult given these facts.
What if the economy improves? After all, some economic data show that the economy may be finding its footing, leading some to believe interest rates could be raised earlier, as soon as next year. Based on the data above, however, the question isn't, “When will rates rise?” but rather “What does inflation do?”
In other words, interest-rate fluctuations in and of themselves aren't important to gold; it's how the rate interacts with the inflation rate. If inflation simultaneously rises and keeps the real rate negative – something that seems a near certainty in our view – we should expect gold to remain in a supportive environment.
One more point. You'll notice in the above charts that this trend doesn't reverse on a dime. It takes anywhere from months to years for investors to shift from interest-bearing investments to metals – and vice versa. And the longer the trend, the slower the change. Real rates have been negative for a decade now, and with broad institutional investment in gold largely still in absentia, it's reasonable to expect the trend in gold won't shift any time soon.
The Message for Gold Investors
Armed with these data, there are reasonable conclusions we can draw and action steps we can take with respect to gold.
Despite the current weakness in prices, we remain in a bull market for precious metals. Further, real rates are likely to continue to be negative for some time for the simple reason that we think inflation, once it gets started, will rise for some time. Ask yourself: Will the Fed and other central banks raise rates aggressively enough to catch up to inflation? Someday, sure, but not any time soon. Therefore:
Don't get flummoxed when you hear talk about rising rates. Watch the real rate instead. This means…
You can buy gold today. As long as real interest rates are negative, gold will remain in a bull market. If you already own some gold, you can and should ask yourself if it's enough at a time when money in the bank is a losing proposition.
When real rates turn positive, especially above 2%, it may be time to sell. We'll have to see what's going on in the world at that time; if there's financial chaos, the fear factor could cause gold to depart from this historic pattern. But even if not, keep in mind that while the price of gold fluctuates every day, the shift out of gold-based investments won't occur overnight. There should be time to gain clarity.
The bottom line is that we can take comfort in the fact that the strongest historical indicator of all tells us the gold bull market is alive and well and has years to play out.
Jeff Clark is editor of BIG GOLD, and a regular contributor to the Hard Assets Alliance.