Rising Interest Rates Are Excellent For Gold
Part 2
19 June 2007
In Part one of this article, I corrected two popular misconceptions held by contemporary professional money managers concerning interest rates and the price of gold.
1) Increases in interest rates make debt more attractive and gold less desirable. This would make the value of gold, like bond prices, inversely related to movements of AAA debt yield.
2) Debt yields dollars for income, gold collects dust. The prime consideration for conservative investment funds is to yield income. Inflation risk to principal is a non-factor in the current regulated financial market place.
Part two of my article will focus on the third misconception concerning bond yields and the price of gold.
3) Interest rate volatility drives the gold market. This implies that changes in yields are actions, while price changes in the gold market are reactions to interest rates.
Using a 10 week moving average, I've charted long term US Treasury bond yields and gold from 1967 to the present time, this is an interesting chart.
In the above chart from 1967 to August 1971 there was a direct connection between gold, and money. The Bretton Woods Accords (BWA) fixed the US Dollar at $35 paper dollars for one ounce of US Treasury gold. This direct connection between gold and money was broken in August of 1971 when the "gold window" at the US Treasury was closed. Henceforth, the US Government refused foreign central banks any future redemption of their US paper dollars for US gold. Since 1971, foreign central banks have accepted US Treasury debt instead of US gold for reserves purposes.
The BWA link of $35 paper dollars to one ounce of US gold was a check on paper money creation. Since paper was first used as money, excessive creation of paper money to gold reserves created economic and financial problems that resulted in ruin for people world wide. Savings in paper money that represented a life's time of hard work and thrift became worthless, countries and their citizens were made destitute. The $35 paper dollars to one ounce of gold was the promise in the BWA that the United States Government would not inflict the hardships of inflation upon the world as so many other governments have done in past centuries.
However, after World War II, the United States was in a difficult position. It found itself in a lingering cold war that seemed to have no end and a "space race" with the Soviet Union; it wanted to create the excellent interstate road network linking the nation from coast to coast and from Mexico and Canada; also Americans were demanding an increase in social services. This all took money, much more than the $35 dollars to one ounce of US gold could provide. The below chart graphically shows how much more US paper money has been placed into circulation since 1971 when the "gold window" was closed and US currency creation was freed from the BWA's gold link.
Currency in Circulation (CinC) is the coins and paper bills circulating in the economy, it also forms the basis of bank reserves. Banks in the course of their business take in one dollar from deposits, or borrowed from the Federal Reserve and lend that single dollar to ten or more people. This multiplication of dollars coming into a bank and money leaving a bank in the form of loans checks is called bank credit. The dollars contained in CinC are multiplied many times in this process. The results are recorded as the Monetary units called: M1, M2 and the now discontinued M3.
This problem of exponential expansion in bank credit is international in scope. US Treasury bonds are monetary reserves world wide. Since 1995, global bank credit has quadrupled at a minimum.
So what link can be established between bloating bank reserves and the price of gold or interest rates? The current monetary system's debt based credit cycle itself. It is important to understand that the current monetary system's use of debt for bank reserves creates financial incentives and consequences for creditor and debtors that evolve as the credit cycle matures.
Early in the cycle, bank loans produce real economic benefits for creditors and debtors. Owning yielding debt is also profitable, for instance with a money market account or bond mutual fund. At the end of the cycle, it becomes apparent to the prudent that the credit system has become dangerously destabilized; massive debt defaults are pending.
Defaults are always inevitable with this system of banking. Without gold reserves to limit currency creation, banks can painlessly create currency upon demand and without limit via their loans checks. Note how loans are never paid out with cash as that would defeat the purpose of the banking system. Unfortunately, business profits and employee wages that service this debt cannot expand upon demand. As the credit cycle matures, debtors' ability to service their debts become burdensome, leaving few resources to pay for other basic needs. The cycle terminates as business profits and wages are consumed in debt service and the system enters a phase of systemic credit defaults ending with collapsing asset prices.
Currently there are signs that the current credit cycle is entering into its terminal stage, such as the story below.
Minnesota is very cold in the winter time. Why haven't these Minnesotans paid their heating bills from last winter? What about next winter? I suspect that most of these delinquent utility customers are the marginal borrowers to whom banks and mortgage companies freely lent hundreds of thousands of dollars. This is horrible! But this is what happens when the banking system is allowed to suck the economic life out of people.
What happens to the financial assets that these homes and business represent if these people can no longer service their mortgages? All too many of these houses will join the growing number of homes in Minneapolis and Saint Paul, Minnesota that have been abandoned and vandalized for their copper water pipes and electrical wires. How far will the fair market value of these houses fall a year from now even if interest rates do not rise?
If these people owe on average $1,500 to CenterPoint Energy, what do they owe the banks? If the average mortgage is $200,000 (not an unreasonable sum for a Minnesota mortgage a year ago) this StarTribune story is flagging a potential $41 billion dollar default in the American mortgage market. Is it possible that this is happening only in provincial Minnesota? In June 2007, are huge American cities like Chicago or Boston exempted from sub-prime mortgage "credits" being forced to chose between heat and loan payments? Can these people purchase food, clothing and gasoline? Most likely yes, but only when they stop servicing their debts to the banks.
Leonard Kaplan favors debt instruments yielding an income over gold in a rising interest rate environment. I don't doubt his sincerity, but does he really understand the financial hardships now endured by common people who must service this debt? At some point these people are going to walk away from their debt as it is back breaking. The system can take legal actions against them. Bankruptcy laws in the US have been stiffened to protect creditors, but all too many debtors have no more to give.
One last point, the financial debt market has become a bloated thing since gold sold for over $800 an ounce in 1980. The market capitalization of the gold and silver market is only a minute fraction of the capitalization of the global financial markets that trades bonds and stocks. If just a very tiny portion of the debt and stock market were to bleed off into the gold and silver markets, this minuscule reallocation of assets between these two markets would have a huge effect on the price of gold while having no visible effect on the international financial markets. The same would be true with a reverse in flows. Due to the differences in scale of these two markets, fund flows from financial assets have huge effects upon the gold market, but fund flows from the gold market have small to no effect upon the financial markets.
I am not suggesting that every flutter up or down in the gold market is due to direct capital transfers between gold and financial assets. But when concerns of default or rising inflation risks arise in the bond market, it is logical that the precious metals markets would give early indications of flight capital leaving financial assets. I believe this is why the trends in these two markets - bond yields and the price of gold - are sympathetic with each other, but not simultaneous or proportional. Think of gold as being more a barometer than a thermometer for the credit markets.
Keep that in mind when considering the very first chart at the top of this article. Gold's 10 week moving average is now at all time highs while US Treasury long bond yields are at lows not seen since 1967. In the past seven years both gold and bonds have gone to historical extremes in opposite directions to each other. This has never happened before. Bonds have never paid out so small a current yield since gold has been freed from direct overt price controls in August 1971. The summer of 2007 is a unique moment in the history of these two markets.
As time passes, my personal opinion is that bond yields will increase due to soon to be apparent, debt defaults. In such a case, gold will shoot for the moon as interest rates follow upwards and bonds crash. This is what happens in gold bull markets - interest rates rise to extremes as debt default becomes common. In the past, gold at such times was seen as a safe harbor for panicking capital. But the smart money, as usual, comes in early. I think that is what the price of gold is telling us.
All this assumes that the monetary and economic "policy makers" allow the credit system to cleanse balance sheets with deflation via defaults and bankruptcies. However, they may decide that deflation is too painful. I would not be surprised to see politicians and economists making attempts to manage asset prices at near current levels with even more loans to crippled credits. This is actually the most likely scenario they would take. However, while this may maintain assets at specified price levels, this policy risks hyper-inflation and the destruction of the US dollar itself as an economic asset. In either case, gold or silver is not a bad thing to have in one's portfolio today.
Note on my charts below. Using a 10 week moving average, I used the data in my first chart and cut it up into more manageable charts. Vertical dashed lines on key gold price moves (blue plot) have been added to aid in referencing the time line.
On the * BIG MOVES * in gold and bond yields, does gold lead or lag bond yields? I have my own opinion but I'll let you make the call for yourself. This is actually a multi-trillion dollar question that will make some and break others so you have better get it right.
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