As summer officially begins in the northern hemisphere, the financial markets are increasingly taking a back seat to the wonderful joys of summertime. When compared to beach vacations, backyard barbecues, and exploring the great outdoors, the endless stream of information blasted worldwide by the markets seems much less alluring.
In the States and Europe, the markets often seem to slip into suspended animation during the prime summer months, waiting until late August to sleepily emerge from cryogenic stasis. This expected seasonality is a good thing, as it is important for every investor and speculator to take a mental break and disconnect from the perpetual market circus now and then.
Researching and writing in the summer is a lot of fun because overall volatility tends to drop across many popular markets. This reduced volatility leaves more time available to explore other areas of interest that are not as sexy as watching the stock indices and commodities prices but are nevertheless quite important in the grand scheme of things.
One of these less popular financial arenas is the oft-ignored but fantastically influential world of real interest rates.
Interest rates are simply the price of money. You can lend money for an interest rate yield or borrow money for an interest rate price. Interest rates define the equilibrium price point where creditors and debtors meet in a free market. The creditors are savers who have earned more income than they have consumed so they are looking for a destination to deploy their surplus capital to earn a fair return. The debtors feel the need to run a deficit and spend more money than they have produced so they are willing to pay a fair price, an interest rate, for the privilege of borrowing others’ surplus capital.
Real interest rates are simply the market interest rate (also called nominal rate) less the rate of inflation. Real rates are what savers actually earn on their surplus capital after inflation. Real interest rates are exceedingly important for creditors, debtors, investors, and speculators worldwide. The more one ponders real interest rates, the more apparent it becomes just how universally influential they are for so many crucial market arenas.
Last summer I penned an essay called “Real Rates and Gold.” At the time, real interest rates were plummeting to earth like the tragic episode this week of the C-130 fire-fighting airplane that crashed when both of its wings suddenly snapped off its fuselage in flight. Real interest rates appeared destined to auger in and plunge negative for the first time since 1980.
Today, almost a year later, it is amazing to behold that the real interest rates somehow pulled out of their doomed power-dive and avoided carving out a fresh smoldering crater in the financial landscape. In this essay, we will update our key graphs from last year’s “Real Rates and Gold” and discuss the implications.
To calculate the real interest rates, we attempt to deploy the most conservative possible data for both components of the real interest rate equation, the risk-free nominal interest rate and the rate of inflation. When analyzing real interest rates, it is also very important to be careful to compare nominal interest rates and inflation rates over the same time horizon. As interest rates are universally quoted and trafficked in annual terms, we utilize one-year rate data in all our real rates graphs.
For the nominal interest rate, we are using the constant maturity 1-Year US Treasury Bill yield. US Treasury yields are universally considered to be the benchmark “risk-free” rate of interest worldwide. Virtually every major interest rate in the United States and many critical global rates are derived from the yields on US Treasury bills, notes, and bonds. The Federal Reserve publishes the 1-Year T-Bill yield once a month and is our source for this data. In the following graphs, the 1-Year T-Bill yield is depicted with the black lines.
For the inflation rate, we continue to begrudgingly use the US Consumer Price Index. The CPI is widely believed to understate inflation for many reasons, but unfortunately the financial markets still look to it as the de facto standard of inflation in the US. I have written several essays on the flawed CPI in the past including “Lies, Damn Lies, and CPI.” Until more market participants see through the hype and hedonic distortions of the CPI data it will sadly remain the accepted baseline for inflation. The inflation rate used in these graphs is the year-over-year change in the CPI, a single year proxy of the widely accepted US inflation rate. The annual CPI increase is graphed below with the white lines.
We decided to actually chart the 1-Year T-Bill yield and YoY CPI change in this latest iteration of our real interest rates graphs to provide more information and to show how these two ingredients of real interest rates interact.
When the annual CPI increase is subtracted from the 1-Year US T-Bill yield, the real interest rate is the result. Real interest rates are graphed below in blue and red, blue if they are positive and red if they slide negative. Gold, one of the crucial global markets that real interest rates affects so intimately, is graphed in yellow. All data in this essay is monthly.
Let’s begin with the updated long-term strategic overview we originally presented last summer.
Each time real interest rates have plunged negative in the last three decades or so, gold has rallied, sometimes dramatically. The last major episode of negative real interest rates occurred in the 1970s and gold soared to the stratosphere in its biggest rally in recent history. I discussed this graph in depth in last year’s “Real Rates and Gold” installment if you would like to digest more analysis on this topic.
Why does gold soar when real rates approach or slice through zero? The answer is simple and an understanding of these dynamics is very valuable as it brings many other apparent market anomalies into proper perspective.
Building wealth is hard work. Few, if any, shortcuts exist and it takes diligence, persistence, and sacrifice over years or decades to amass significant amounts of capital. The only way for a nation, company, or individual investor to become wealthy is to consume less than they earn. Savings is the key to wealth accumulation. While initially a saved surplus seems to grow excruciatingly slowly, eventually it starts to accelerate and ultimately ramps up parabolically due to the “miracle” of compound interest.
Because it is such hard work to accumulate large amounts of surplus capital, the folks with the fortitude, courage, and wisdom to pull it off rightfully expect that they should be rewarded for their Herculean efforts. Savers, synonymous with investors and creditors, deploy their hard-earned surplus capital through the global financial markets. They expect to “lend” their surplus capital to others, either as a creditor or equity investor, and earn a reasonable return on their capital.
The reasonable return for savers must exceed the rate of inflation. If general price levels increase by 10% next year but a saver can only earn 5% on his or her precious capital than it makes no sense whatsoever to deploy the capital. Why lend surplus capital if inflation effectively erodes away and destroys principal because nominal and real rates of return are too low?
When real interest rates, the true return on surplus capital, approach zero or even worse slide negative, a tremendous disruption is unleashed that cascades through the capital markets. Savers, rather than lending their surplus capital to various debtors in the hopes the debtors can use it to create valuable goods and services, often decide to simply quit deploying their capital since they are being robbed of their hard work after inflation.
Low or negative real rates cause the capital markets to slowly seize up as savers are cast onto an unfair and uneven playing field with debtors. Witness Japan and its confiscatory and dysfunctional artificially-low interest rate policy that leads savers to hoard their surplus capital rather than investing it.
In these environments hostile to capital accumulation, savers seek alternative investments like gold. Unlike fiat paper currencies which can be printed and inflated at will by spineless politicians and their toady central bankers, the global supply of gold is very limited and only grows very slowly year after year as more gold is mined.
Historically gold always thrives in inflationary environments, which are usually synonymous with low real interest rate environments. If real interest rates are so low that the financial markets are effectively punishing and confiscating the hard-earned capital of the savers, why should savers even deploy their capital into losing investments? Gold as an investment becomes hyper-seductive and prudent in these times!
The real interest rates are also exceedingly important for other key financial arenas including the massive foreign exchange markets. If one country has low real interest rates savers from other countries will, after enough torture and abuse of their capital, simply pull the plug and take their hard-earned surplus savings elsewhere. I strongly believe that the accelerating fall of the US dollar we have witnessed thus far in 2002 is partially a consequence of the terrible real rate environment in the States that has failed to reward foreign investors.
Low or negative real rates effectively stealthily plunder capital from savers and give it to debtors, and savvy savers worldwide certainly realize this so they pull their capital out of the low real rate environment and seek other nations with fair real rate environments in which to invest.
All free-market economic transactions must be mutually beneficial. In order for a saver to lend money to a debtor, both the saver and the debtor have to believe that they are getting a fair deal. While low real rates help debtors because inflation erodes away their real debt, low real rates immorally bleed capital from savers. Because market interest rates are unfortunately pegged to nominal rather than real interest rates, in low interest rate environments the savers can’t get a fair deal so they simply pick up their toys and move to another sandbox. And who can blame them?
Zooming into the dataset since 1990, some other provocative developments become more apparent.
Even in the 1990s, an epic decade defined by the greatest bull market in equities in three generations, the gold price was strongest when real interest rates approached zero. The two largest gold rallies of the past decade are marked with white arrows above, both erupting as real interest rates plummeted to abysmal levels and punished savers. Conversely, the gold price tended to wax the weakest when savers could find a reasonable return on their capital elsewhere such as in the late 1990s.
It is interesting that both the current and early 1990s low real rate environments occurred immediately after the Federal Reserve was mucking around in the free market by playing short-term interest rate games. While technically the Fed only directly sets overnight interest rates used by banks to borrow capital from each other or the Fed, the Fed’s anti-free-market manipulation of the price of money dramatically affects other interest rates as well.
The shorter the maturity of any interest rate, the more it is influenced by the Fed’s Soviet Politburo-style pegging of the overnight bank rates. Interest rates should be dynamically set in the marketplace by supply and demand forces, the free market, not by decree in smoky backrooms full of private, unelected, and unaccountable central bankers.
The black 1-Year T-Bill yield line in the graph above has a short enough maturity so it is affected significantly by the Fed’s endless machinations of inter-bank interest rates. Nevertheless, since US Treasury debt is sold in the open market and countless investors bid on the debt instruments, the price and yield of the T-Bill data is rock-solid. The annual increase in the CPI, marked by the white line above, is a totally different story however.
The classic definition of inflation is relatively more money chasing relatively fewer goods and services. Price inflation is a monetary phenomenon. When paper money is printed faster than the available supply of things on which to spend it, inflation is the inevitable result. Freshly wished-into-existence fiat currency can certainly be spent on other things besides consumer goods, including stocks and houses, but growing money supplies will inevitably cause inflation somewhere.
It is extremely odd and downright disturbing that the US inflation rate, currently a paltry 1.2% per the CPI, is very close to its lowest level since the mid-1960s. Even since 1990, the average inflation rate per the CPI is much higher at 3%. This 3% level is also readily apparent in the graph above as the white CPI line hovered around 3% for most of the 1990s. Also strange, it is extraordinarily convenient that the inflation rate suddenly fell off a cliff just in time to keep real rates from plunging negative in response to the most aggressive rate-cutting spree in Fed history kicked off by Greenspan in early 2001.
In December 1990, the US inflation rate per the CPI proxy was 6.1%, almost 5% higher than today’s government-reported numbers. In 1990 the US money supplies had grown rapidly, initiating inflation, relatively more money chasing relatively fewer goods and services. In calendar year 1990 the Currency Component of M1 (physical dollars in circulation) was up 10.7%, MZM (Money of Zero Maturity, all money not tied up in time deposits like CDs) rose 5.8%, and M3 (overall broad money supply) slowly grew by 1.8%.
More money injected into the system at a rapid pace leads to higher inflation, right? Makes perfect sense.
Compare this 1990 data to May 2002, the latest CPI figure just released, which showed an enigmatic 1.2% inflation rate, almost the lowest in 37 years. In the year ended May 2002, the Currency Component of M1 roared up by 10.9%, MZM rocketed by 14.1%, and M3 exploded up by 7.8%!
Extreme fiat monetary growth equals the lowest inflation in nearly four decades? Give me a break!
Do you smell a rat here?
According to official Federal Reserve and Bureau of Labor Statistics (the custodians of the CPI) data, the CPI came in at a year-over-year change almost 5% lower in May 2002 than in December 1990. Yet today the annual M1CC growth rate is 0.2% higher than 1990, the annual MZM growth rate is a breathtaking 8.3% higher than in 1990, and the annual M3 growth rate is a phenomenal 6% higher than in 1990!
How on earth can fiat money supplies grow at such extraordinary rates and consumer inflation fall to virtually nothing? Even when some dollar inflation obviously feeds other festering bubbles like residential real estate, what about the rest? What about the enormous 10.9% physical-currency-in-circulation growth? Where did all that fresh paper go? No one pays for a house with a box full of $100 bills these days, so I suspect that at least some would be spent by Americans on the common CPI-type goods and services that they need to buy to live life.
Something seems very wrong here! The reported inflation rate, computed and presented by unelected lifetime bureaucrats at the BLS who exist solely to please their political masters, conveniently dropped just in time for Greenspan to continue his assault on savers via artificially-low interest rates. Even more provocative, current monetary growth rates in the US are far higher today than monetary growth rates during the last big inflationary episode in 1990.
I believe that savvy global investors also sense this glaring disconnect. The obvious conclusion to be drawn is that, for whatever reason, the BLS is lowballing reported inflation tremendously. The US government desperately needs low reported inflation numbers and the BLS folks apparently check their integrity at the door and happily deliver like puppets on strings.
High inflation rates increase interest payments on the massive national US debt, increase welfare payments based on cost-of-living adjustments to various powerful voter blocks in the US, and also scare foreigners away from holding the dollar. Foreign investment in the US, in turn, is crucial for the dollar’s strength, the health of the US equity markets, and the financing of the insatiable US consumer appetite for imported goods.
Unfortunately for whoever is trying to play this data-obscuring game with the financial markets, erroneously reporting one thing while another is truly happening only temporarily delays the inevitable day of reckoning. Ask Enron about false reporting. The moment the institutional dishonesty and lies are uncovered, the financial markets punish the culprits viciously, regardless of whether it is a single company or the US government.
With current extraordinary monetary inflation rates, odds are the true real rate of interest in the United States has already plunged negative. Various US Federal Reserve and probably US Treasury officials, fully comprehending the frightening implications of this development, appear to be playing a dangerous game of pressuring the BLS into understating reported inflation as long as Greenspan’s rates remain low. The ruse is apparently designed to dupe investors, both domestic and foreign, into thinking all is well and their hard-earned saved capital is safe.
The current very impressive strategic gold rally as well as the flight of foreign capital from US dollars is likely to continue to accelerate as long as real interest rates remain low or negative. As more and more investors around the world detect that the US government is apparently cooking the inflation books and they are being robbed of the necessary fair real rate of return for the use of their capital, they will revolt.
Ultimately, the United States of America, just like any public corporation, will have to provide honest financial data and earn the trust of savers. All financial lies inevitably revert to the same disastrous mean of turning out very badly for the liars.
With gold rallying strongly and real rates probably already negative in reality, it will be interesting (pun intended) watching how it all plays out.
Adam Hamilton, CPA
June 21, 2002