Bonds vs. Gold
Cliff Droke
The big news this week is that the yield on the 30-year bond slid to a new record low while yields on a benchmark 10-year note probed fresh 45-year lows. The dollar also continued its bear market decline. And while interest rates and the dollar continued to slide, gold prices kept rising, leading many observers to ask, "what has become of the relationship between gold and interest rates (also, bond values). In years past, a rise in bond prices (and thus a decline in interest rates) typically meant a decline in gold prices, yet we have seen in the past year that this relationship is no longer true. Why the disconnect? Is this a case of an unprecedented decoupling in the bonds/gold relationship or nothing more than a normal cyclical occurrence? We'll attempt to answer to this question in the paragraphs that follow.
So why the continued decline in interest rates after a multitude of financial forecasters (including some very respectable ones) confidently affirm that the "bottom is in." Every time we hear this pronouncement rates proceed to make new lows. Shouldn't we have learned our lesson by now? What does this suggest? Plain and simple, it shows that the K-wave is still declining and has not bottomed yet contrary to what many analysts are saying. Technically, the K-wave isn't due to bottom until sometime between 2004-2005, yet it can be manipulated by central bank/federal government economic policies to last much longer. But assuming a textbook bottom, we can expect at least one and maybe two more solid years of the "hard down" phase of the economic long wave, which means continued low or falling interest rates and overall deflation in the financial sector of the economy.
"But interest rates peaked in 1980-81 and have been in overall decline since then," someone protests. "After 23 years of decline we should be seeing the bottom by now, shouldn't we?" Based on historical precedent, no. Realizing, of course, that no two K-waves are exactly alike, yet understanding that there will always be many similarities and parallels, we can observe that in the prior K-wave which bottomed sometime in the early-to-mid-1950s, there was a nearly 30-year declining trend in interest rates. At that time, the interest rates (as measured by the quarterly average of Moody's AAA bond yields) peaked in 1920 and went into an overall decline until around 1945, then spent an additional five or so years bottoming along the lows. And it wasn't until about 1955 that rates took off again and began a new uptrend. So we're talking a 35-year period between the previous peak in rates until the next big upswing began. Yet despite this clear historical evidence there are a number of vocal prognosticators who insist that interest rates will "skyrocket" sometime in the near future. Sorry guys, but it doesn't work this way. Interest rates are basically the cost of borrowing money and banks cannot let out huge loans at high rates of interest until the left-over debt from the previous K-wave binge period are serviced. And the record-level debt on the books today is no way near being amortized.
We all know that a picture is worth a thousand words, so let's examine in picture form the long-term trend in interest rates from the previous two K-waves. P.Q. Wall of the P.Q. Wall Forecast, Inc. (from whom I borrowed this graph) calls this "the single greatest all time chart," and I can't help but agree. Take a look and see for yourself.
So what exactly is the significance of a rise in bond values (which is another way of saying a decline in interest rates)? A rise in bond value sends the message that rates are falling usually due to decreased inflation risk. When interest rates decline in a pronounced downtrend it goes a step beyond mere "disinflation" and enters the realm of outright deflation. But this begs the
question, "deflation of what?" Forgetting for one moment the interminable debate between the deflationist and inflationist camps, a pronounced and sustained decline in interest rates reflects deflation in the overall financial sector, but not necessarily in other areas of the economy. That's really the crux of the deflation argument right now - the deflation the U.S. now faces is mainly focused in stocks, interest rates, and the dollar. As I argued in my Gold-Eagle article from a couple of years ago, "The New Economy of Retroflation," it is possible for the conditions of inflation and deflation to exist simultaneously in an economy, particularly when the inflation is found mostly in consumer goods and certain commodities (i.e., tangible assets) while the deflation is found mainly in financial (i.e., intangible) assets. This especially holds true during a war-time economy (most frequently seen in times of economic depression) when the supplies of certain commodities can be artificially restricted and their retail prices inflated well beyond their actual value.
Now let's bring gold into the picture. Historically a store of value, it becomes widely held and highly valued in times of high inflation as a financial hedge. But in "normal" times when interest rates are declining, and thus bond prices are rising, the demand for holding gold declines as investors prefer bonds and other stores of value. Yet this does not always hold true. As we are now seeing, at the far end of the K-wave (runaway deflation) gold once again becomes a prominent and highly desirable store of value in the eyes of many investors. The relationship between bonds and gold over the past 4-5 years provides justification for the theory I espoused in several Gold-Eagle articles over the past three years, namely, that gold is just as valuable in late runaway K-wave deflation (1998-present) as it is in late runaway K-wave inflation (1975-1980).
Ever since at least 1998 when the entire so-called "global economy" nearly fell apart at the seams, the de-coupling process in the relationship between gold and bond prices has picked up steam. Since then we have seen numerous occasions when the value of the 10-year T-note, for example, rose even as gold prices rose and vice-versa. Again, this strongly suggests that we are in the runaway deflation portion of the K-wave where you can have falling interest rates AND rising gold prices at the same time. The falling interest rates (and thus rising bond prices) point to deflationary concerns while the rising gold price reflects - not concern for inflation - but rather a flight to safety as the financial system, overall, becomes unglued and investors are desperately seeking a monetary safe-haven. Thus wee see that the argument of those gold enthusiasts who insist that interest rates MUST rise in order to gold to rise is false. In the next couple of years we will likely see continued low interest rates and rising gold prices at the same time.
May 20, 2003
Clif Droke is the editor of the Gold Strategies Review newsletter, a monthly forecast and analysis of gold and silver futures and precious metals stocks. He is also the author of numerous books on finance and investing, including most recently "Junior Mining Stock Yearbook 2003-2004." Visit his web site for free samples of his analysis at www.clifdroke.com
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