However, losing money in stocks and bonds, especially the expectation of more of the same, drives investors to consider the merits of safe havens including cash, T-Bills, and gold. The survival of optimism in the aftermath of the dot com crash is a testament to the resilience of institutional and popular memory as well as to the inherent difficulty, at the broadest cultural levels, of recognizing and adapting to new realities.
It also explains why provided an exception to the rule that gold prices tend to vary inversely with those of financial assets. While a rise in interest rates might be presumed in the popular media to be theoretically bad for gold, it is more important to ask and answer several related questions before jumping to any particular conclusion. First, is the prospective rise in interest rates the beginning or the end of a process?
Second, are the increases in nominal interest rates identical to real interest rates? Third, and most important, will the interest rate increases be favorable or adverse for the returns on financial assets? The next interest rate increase will, it can be stated with confidence, begin rather than complete a process. How far must the Fed raise interest rates before monetary policy can be considered neutral rather than aggressively accommodative?
Assuming, for the moment, that measured price inflation is running at 1. Should measured inflation begin to rise, as it did most emphatically in the most recent Consumer Price Index CPI report and as it is doing on an anecdotal basis almost everywhere, to what level would short-term rates have to rise in order to be considered restrictive?
It does not seem far-fetched to suggest, considering the level of existing and prospective budget deficits, the unprecedented build up of debt, the open-ended nature of American military commitments, and the disinclination among political leaders to restructure Medicare and Social Security entitlements, that the year bears a strong resemblance to In that year, the DJII peaked at 1,, a level it would not exceed until The Fed Funds rate was 5.
Returns on financial assets were poor during those 14 years. Gold and gold shares, on the other hand, turned in stellar performance. The decade-long process of undermining public confidence in financial assets was never obvious except in hindsight. It was not a blinding flash of awareness that minimized investment expectations.
Instead, the investment equivalent of Chinese water torture, a repetition of bad experience sufficient for mass extrapolation, caused investors to demand single-digit equity multiples and double-digit coupons for 30 year treasuries.
The entrenchment of mistrust depends on deception, both externally applied and self-induced. In due course, history will reveal multiple deceptions at the core of the current bear market. For the financial markets, the disparity between nominal and real interest rates was central. During the decade, sky-high Fed Funds did not provide a positive yield due to an even higher rate of inflation.
Real interest rates stayed in solidly negative territory from through A core deception of the moment is the notion that a few up ticks of 25 to 50 basis points in short term rates will be sufficient to arrest the forces of inflation set in motion by the most aggressively accommodative Federal Reserve in history.
Real interest rates, defined as the 90 day T-bill discount rate less trailing twelve months inflation, are negative by approximately basis points see chart below. This is, no doubt, a very gold-friendly statistic. A few hundred basis points of rate increases over the next twelve to eighteen months raises the possibility that this measure will no longer be so friendly.
On the other hand, if measured inflation rises in lock step with the rate increases, the environment will remain positive for gold. To predict real interest rates 18 months hence would require insight unavailable to most mortals and certainly to this writer. There are two components to the equation. Variable A is the future trailing twelve-month rate of inflation. Future CPI releases will be closely watched to see if inflation maintains the torrid pace suggested by recent data.
Variable B lacks the apparent exactitude of the first. It is the measure of aggressiveness yet to be employed by the Federal Reserve Board in countering the incipient inflationary threat. While we have our own ideas on this matter, the behavior of the gold price in future months will provide the necessary illumination. Hedonics is the science of adjusting product prices for qualitative improvements enabled by technology.
Nearly all of these adjustments result in lower rather than higher price measurements. Although the Office of Federal Housing Enterprise Oversight measures the increase in housing prices at 7. Readings from the tricked up CPI of amount to little more than radar-confusing chaff.
Other key indicators guiding economic policy may be similarly flawed. Will the financial market add the missing basis points back to the CPI in calculating the real interest rate? Our guess is that it will not. Understatement of inflation by the CPI will ultimately disenchant investment expectations.
An inaccurate read on inflation will justify prolonged monetary ease. A continuation or widening of the present disparity between nominal and real interest rates is an important premise for a commitment to gold. Finally, what collateral damage would arise from a multi-year rise in interest rates sufficient to quell gathering inflation? Which is more visible and which is easier to hide? Since the days of Volcker and Reagan, the sensitivity of the US economy has shifted dramatically away from the price of copper and other raw materials and towards the price of money.
The Fed has said as much in numerous speeches. The gabby Greenspan Fed has failed to communicate to those offside in junk bonds, overpriced equities, interest rate swaps, emerging market sovereign debt, and all other unfathomable reaches of the carry trade of the stark choice between tolerating a further buildup in inflation or aggressive rate increases that would choke the economy and collapse the carry trade. While Mr Summers and Mr Barsky went on to other topics, others updated their study over the years.
So, between and large capitalisation stocks earned annual returns of During the last gold boom, between and , gold earned an annualised return of I called Mr Summers to discuss his old paper, and the s real returns results. While the real returns on risk capital fit the model very well, real interest rates in the late s were below the predicted trend. The equity return numbers do make sense.
These shocks reflect changes in the actual or perceived productivity of capital. Real interest rates in the late s, however, were held down below where they should have been. So real interest rates during this period did not track real returns as they should have. This has been turned into a conspiracy theory by goldbugs. Ignoring the tight negative correlation between equity returns and gold, they have focused on the low interest rates, concluding that they illustrate a suppression of the gold price.
I went to see Mr Barsky to discuss this interpretation. He has not been close to Mr Summers in the intervening decades but dismissed the notion that the former Treasury Secretary was carrying out some conspiracy to suppress gold. In any event, the causality we identified in our paper was: real rates of return drive real interest rates and the gold price. There was, many would argue, a policy failure from the late s to the end of the Greenspan era: monetary policy was too loose, and that is leading to serious trouble.
Manage cookies. Central banks. John Dizard June 26, Central banks updates. Reuse this content opens in new window Comments Jump to comments section.