Gold and the 'Real' Interest Rate
Steve SavilleOn a month-to-month or even a year-to-year basis the relationship between gold and interest rates is not very strong. Over the long-term, however, there is a very powerful relationship between the gold price and the CPI-adjusted (sometimes called the 'real') interest rate. To help explain this point we'll use the following chart comparison of the gold price and the CPI-adjusted Fed Funds Rate (FFR). By the way, in our chart the CPI-adjusted FFR is calculated on a monthly basis by subtracting the annualised change in the median CPI from the average Fed Funds Rate.
The above chart shows that:
- The CPI-adjusted FFR spent the entire decade of the 1970s below 1% apart from a few short-lived spikes above this level.
- The CPI-adjusted FFR spent the 1980s and the 1990s above 1% apart from a few short-lived spikes below this level.
- The CPI-adjusted FFR has spent the past 3 years below 1%.
Now, we don't think it's a coincidence that the secular gold bull-market of the 1970s corresponded with a persistently low CPI-adjusted FFR while the secular gold bear-market of the 1980s and 1990s corresponded with a persistently high (relatively speaking) CPI-adjusted FFR. Furthermore, we are not surprised that the persistently low CPI-adjusted FFR of the past few years has coincided with a strengthening gold price. In fact, it is clear to us that gold is a beneficiary when the Fed holds short-term interest rates at a low level (relative to the rate of change of the CPI) for a lengthy period of time.
As well as being consistent with the historical data this makes intuitive sense because US$-denominated investments will tend to lose their appeal when 'real' returns are very low. And when the investment demand for the dollar is falling the investment demand for the dollar's main competitor (gold) gets a boost.
What is also clear, at least in our minds, is that once a gold bull market is underway it continues until the Fed is forced to take aggressive action to quell the inflation fears (a rising gold price is one manifestation of these fears). The question is; how high will the gold price (and commodity prices and long-term interest rates) have to move during the current cycle before the Fed decides that enough is enough? This is a question that can't be answered at this time, but the gold price is certainly going to have to move a lot higher than it is right now because Greenspan and Co. are still insisting that short-term interest rates will stay near their present low level for the foreseeable future. And, more to the point, most people believe them!
Why the Fed will have to hike
The Fed never wants to keep the CPI-adjusted Fed Funds Rate at around 0% or lower for extended periods, but sometimes it is forced to do so because the economy is weak. However, the problem that central bankers always run into when they keep short-term rates too low for too long is that inflation expectations begin to spiral out of control. As inflation fears build, partly as a result of excessively low short-term interest rates, the gold price, commodity prices and long-term interest rates all move higher (the most important determinant of long-term interest rates is the expected future inflation rate). The result is that at some point in the cycle it becomes counter-productive to keep short-term interest rates at a low level and the central bank is forced to start hiking rates even if the economy remains weak.
The 1979-1982 period provides a good, albeit extreme, example of what we are talking about. During much of this period the US economy was weak and the unemployment rate was increasing, but the Fed was forced to move short-term interest rates sharply higher by a rampaging gold price and rising long-term interest rates.
In other words, at some point inflation fears rise to a level where aggressive rate hikes by the Fed are needed to bring about a REDUCTION in long-term interest rates.
The market's interest rate expectations
In a letter sent out to his millions of readers at the end of last week John Mauldin argues that the bond market is expecting way too much in terms of Fed rate hikes over the next year. Specifically, he points out that the eurodollar futures market is anticipating a 0.75% rise in the Fed Funds Rate between now and next August and a 1.71% hike between now and next December. He then argues that these expectations are unrealistic given a) the likelihood that the economy will weaken again next year, b) the upcoming Presidential election, and c) the Fed's 'promise' to hold rates at a low level for a long time to come. Mr Mauldin's letter can be read at www.2000wave.com
Our view, though, is that the increase in the Fed Funds Rate over the next year will be a lot greater than the market is currently expecting. Our reason for thinking this has to do with what we've just discussed above.
The Fed's ability to hold the FFR in the 1.0%-1.5% range doesn't directly depend on the economy or the unemployment rate or income growth or capacity utilisation, it depends on what the market does with long-term interest rates. If inflation fears build to the point where long-term interest rates march beyond 6% and appear to be well on their way to 7% or higher, the Fed will start raising short-term rates with some urgency regardless of how weak the economy happens to be. It will simply have no choice because once inflation expectations get out of hand higher short-term rates are needed to reverse the upward course of long-term interest rates.
As an aside, it's important to differentiate between inflation and inflation fears/expectations. Inflation is money-supply growth and it is certainly possible to have high inflation whilst inflation fears remain low. The past five years are proof of that. It is also possible for a sharp rise in inflation fears to occur in parallel with falling inflation (falling money-supply growth). In the current situation there has already been more than enough money-supply growth to generate the visible effects of inflation, which, in turn, tend to generate inflation fears.
With the above in mind, the most likely cause of inflation fears over the coming 12 months would be substantial gains in gold and commodity prices. Since our other work leads us to conclude that substantial gains in gold and commodity prices are on the cards, we think the market's current expectations for the Fed Funds Rate will prove to be too low.
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24 October 2003
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