When Both Rates & Gold Skyrocketed:
Oil/Inflation/Interest Rate/Gold Cycle of the '70s
Kevin DeMeritt
President, Lear Financial
It's almost a knee-jerk response.
"Interest rates heading higher? Well, gold must be heading lower. That's a no-brainer."
You don't have to look far to find analysts parroting that line. But analysts and experts aren't the only ones. Most investors are in the higher rates/lower gold camp, too.
Period. End of story.
Well…maybe not the absolute end of that story.
There are always exceptions to every rule. And some of them are, well, exceptional. Case in point: the late '70s when interest rates reached unthinkable heights at the same time did gold.
Déjà Vu All Over Again
-the Late '70s Revisited
It was a crazy time. You had oil hitting record highs. There was an invasion of Afghanistan, revolution in Iran, war preparations in Iraq, war fears in Israel, and an overall state of heightened world tension. There was also rampaging inflation. And interest rates galloping to catch up.
Gold, too, hit record highs.
If all that sounds the slightest bit familiar, it may be because the '70s bear an uncanny resemblance to our time today (except for the rampaging inflation part…at least if you trust today's official inflation rate). More on that in a moment.
This oil/inflation/interest rate/gold dynamic of the '70s is worth examining. The stage was set when America's domestic oil production peaked in 1970, and we had to start looking elsewhere for our petroleum. At that point, OPEC was a floundering, fledgling organization struggling to lay the groundwork for a petroleum monopoly. Of course, the more we relied on Middle East oil, the more groundwork OPEC laid.
The 4th Arab/Israeli War, erupting on Yom Kippur, October 6, 1973, made the extent of our reliance obvious. Just two weeks later, the Arab oil producing nations ordered a total ban on oil exports to the US. This was the now-famous OPEC oil embargo. It didn't last very long: The embargo was lifted in January of '74, long after hostilities had ceased. But it still extracted a heavy toll: Oil prices rose to an unthinkable (for the time) $12 during the ban, settling into a still high $6.87 per barrel price for the rest of the year.
As predictably as smoke follows fire, inflation surged, too, leaping to 12.3 percent that year, an unheard of rate in the wake of Nixon's wage and price controls.
And interest rates? When war in the Middle-East struck, the prime rate hit 10 percent, peaking at a stunning 12 percent in the middle of 1974 (from just 6 percent a year earlier).
In the midst of that, even as rates were doubling, gold rose 190 percent in just two short years, ending 1974 at a record $183/oz. So…
For the Second Time in the '70s,
Both Interest Rates and Gold Rose Simultaneously
The first time was between April '72 and September '73. But both "simultaneous risings" wouldn't be the last for the decade.
With oil winding higher in the mid-'70s, nothing the government tried seemed to calm things. The only thing that did work was a natural consequence of these economic extremes. 9 percent unemployment-the highest rate since the Great Depression-cooled inflation between '76 and mid-'78. But that was barely long enough for the economy to reset itself for the next round of "oil shock."
The first oil shock happened after the overthrow of the Shah of Iran in late '78. Iranian oil production, formerly a safe bet for the US, took a drastic cut from 5.2 million barrels in '78 to 3.2 million barrels in '79 to 1.7 million barrels in '80.
That helped crank the cycle up again. Oil prices in the US soon rose 30 percent to $9 a barrel in '78. Inflation again followed, jumping to 9 percent. Trying to catch up, the prime climbed back to nearly 12 percent-even as gold crossed the $200/oz barrier for the first time ever.
Household Energy Costs Increased 37.5 Percent in 1979
…And Everything Else Followed
Just a year later, oil spiraled higher to $12.64 for another 40 percent jump. And everything else was right on its heels: Inflation rose to 11 percent, interest rates hit a jaw-dropping 15.25 by year's end, and gold crossed first the $300, then the $400 barrier, hitting $455 on its way to averaging $306/oz for the year.
But the economic extremes weren't over yet.
In 1980, oil prices reached $21 a barrel due in large part to the second oil shock, Iran invading Iraq, and a drop in Iraq's oil production by a million barrels. Accordingly, that spurred inflation to 13.58 percent. The prime answered with an almost loan shark 20 percent rate on April 2nd. And gold? It hovered in the $500 vicinity on that April 2nd day, after setting the current $850/oz record on January 21st (thereby smashing the $500, $600, $700 and $800 barriers)
It should come as no surprise that there are other instances of interest rates and gold rising simultaneously. And of oil leading the way. For example, in '87 and '88, interest rates responded to higher oil and inflation by rising from 7.75 to 10.5 percent.
Meanwhile gold rose from $390 to a high of $499.
So What Does All This Mean for Us Today?
Now, in mid-2005, oil has just topped $66 a barrel for the first time in history. As we've seen, that can be an awfully foreboding signal.
According to the Federal Reserve Bank of Dallas, "nine of the ten post-World-War-II recessions were preceded by sharply rising oil prices."
Higher inflation being so common a consequence of rising oil, the Fed will likely step in and combat it with its weapon of choice. But just as in the '70s, higher interest rates are no panacea. There can be so much weakness inherent in the economy, so much "oil shock," so much debt, so much doubt, that rates simply fail to gain the expected traction.
When that happens-and when the majority of people see the inability of higher rates to calm the economy, just like in the late '70s-then their attention can be drawn to other means of economic control. Like precious metals.
Hopefully, the economy will digest our record oil prices without so much as a hiccup. But isn't it good to know that, should both inflation and interest rates go stratospheric, gold has already "been there and done that" and demonstrated it can be the one healthy asset that gives you the peace of mind everyone else is seeking?
Kevin DeMeritt
www.goldcentral.com
July 22, 2005
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