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Real Rates and Gold 6

Adam Hamilton
January 31, 2004

One of the most important fundamental drivers behind the current fabulous golden bull in US dollar terms is the surreal negative-real-interest-rate environment that now plagues Americans courtesy of the Federal Reserve.

Negative real rates are relatively rare in financial history, as they represent an inherently unstable and artificial state created by central bankers attempting to try and seduce their countrymen and corporations into piling on ever increasing amounts of debt.

The central bankers hope that the rocketing debt growth spawned by negative real rates will ultimately translate into economic growth as the fiat cash injected into the system by spiraling fractional-reserve debt creation soars. They hope this debt-injected cash will precipitate an economic boom.

Negative real rates create enormous problems though, as they effectively steal from hard-working savers to subsidize wastrel debtors. In normal markets both savers and debtors are offered fair prices for capital, for both lending it and borrowing it. Mutually beneficial transactions for both parties are possible, and capital-market commerce thrives.

In negative-real-rate environments, a central bank artificially manipulates short-term interest rates so low that they are actually driven below the official rate of inflation. This means that savers and investors actually lose real purchasing power by lending and investing their capital. $100 that they lend this year might return as $101 in nominal terms next year, but this $101 can really only purchase the equivalent of $99 worth of goods today. True purchasing power, and hence real wealth, is gradually hemorrhaged.

Over time, these negative real returns decimate the savers and investors in the capital markets. Debtors, like parasites or vampires, gradually suck the life out of savers as they are offered unfair and artificial deals due to brazen central-bank short-rate manipulation. Instead of savers and debtors being able to enter mutually-beneficial transactions, win-win situations, savers are forced to only be able to lose purchasing power while the debtors greedily gobble it up.

Savers are faced with an unpleasant choice in these environments hostile to wealth creation. Do they lend their capital to borrowers at a negative real return, fully realizing that they will lose purchasing power and wealth every year, or do they just quit lending entirely and try to protect their capital from central-bank depredation by any possible means?

Sadly in America today, we are slowly learning the answer to this crucial question. In a desperate gamble to try and reignite a failed stock-market bubble, Alan Greenspan and his Fed are remaking a terrible mistake that has only led to pain and misery throughout history. US real rates have been bludgeoned relentlessly lower since 2000, and the bitter fruits of officially plundering savers to subsidize debtors are slowly becoming apparent.

American savers and investors are gradually starting to understand the perils from the Federal Reserve's orchestrated attack on their wealth and are taking appropriate action to protect the hard-earned fruits of their labors. Slowly, but relentlessly, more and more are taking refuge in tangible assets that the Fed cannot devalue or destroy. The king of these negative-real-rate refuges is the Ancient Metal of Kings itself, gold.

Way back in July 2001, when gold was trading under US$270 per ounce and few believed that a glorious new gold bull was even possible, let alone a high probability, I penned my original "Real Rates and Gold" essay. I closed it with, "As the hard-earned capital of bond investors is wrongfully expropriated through inflation and negative real interest rates, we fully expect a significant portion of that capital to make a mass exodus to the rock-solid financial refuge of gold."

And so it came to pass. Real rates had not yet plunged negative in the States in July 2001, but they were hovering perilously close after the infamous Greenspan Gambit to reignite a failed supercycle equity bubble was launched. Not long after that they shot negative for the first time in decades. As expected from hard historical experience, more and more savers recognized this dire warning signal and fled into the fortress of gold rather than wait around helplessly while debtors directly plundered them through immorally low prices for capital.

Today, as a gold investor and speculator, I like to update and reexamine our real-interest-rate and gold charts about once every quarter or two, to keep an eye on the progression of both the gold bull and the Greenspan War Against Savers. As we haven't looked at real rates and gold since September, this week seemed like a great opportunity to update this absolutely crucial analysis for savers, anyone who has worked hard enough during their lives to accumulate surplus capital.

We'll begin with the latest update of our grand strategic chart, which vividly illustrates just how bullish for gold negative-real-rate environments truly are.

As you can see during the past few years of this long-term chart, we are now blessed to be living through and growing wealthy in the greatest bull market in gold since the mid-1980s or so! Gold has soared from just over $250 to around $425 since this awesome new bull began, and real rates have plunged from around 3% down to negative 2% at worst over this same period of time. Savers are migrating into gold, as expected.

The Big One, the massive gold Great Bull and ultimately bubble of the late 1970s, also corresponded with a similar negative-real-rate environment that was officially hostile to savers trying to painstakingly accumulate capital. The first decade of this chart is incredibly eye-catching, as the entire 1970s were dominated by terribly unfair real rates penalizing savers and the resulting mass exodus into gold for capital preservation was breathtaking.

Really anytime in the last few decades, whenever real interest rates plunged under positive 1% or so for an extended period of time, gold managed to achieve some incredibly impressive to legendary rallies and bull markets. The last major gold bull, launching in 1985 or so, corresponded with a period of time when high real rates were falling like a rock and savers were feeling the pain.

The early-1990s gold rally launched when real rates flirted with zero. And of course the present 2001 gold bull ignited when the US Fed foolishly declared war on savers to try and salvage a doomed stock-market bubble, relentlessly driving real rates negative and helping to reawaken a sleeping gold giant with a great and terrible resolve. Few general economic factors are more bullish for gold than a negative-real-interest-rate environment openly hostile to savers!

Gold is a timeless bastion of financial strength, a rare monetary asset with indisputable intrinsic worth in and of itself through six millennia of human history. Unlike paper currencies, which are merely promises to pay in the future backed by nothing but faith in some fallible human government, gold is true money. Gold always has been valuable and always will be valuable, and investors and savers across the globe instinctively know this.

So, when fiat-paper-currency saving and investing is threatened by inflation rates above obtainable nominal interest rates, slowly but surely savers realize that it is foolish to take a real loss in purchasing power and wealth every year just because a central bank wants to unfairly subsidize debtors. Gradually more and more savers decide to withdraw their capital from the usual capital markets and instead park a growing portion in gold, where irresponsible governments cannot erode its purchasing power through inflation and negative real rates.

This is certainly fantastic news for gold, and indeed investing and speculating in gold on the long side are probably the best ways to play a negative-real-rate environment. Sadly though, there are terrible consequences to artificially upsetting the great balance of capital-market commerce. The longer that the Fed holds short rates low enough to rob savers to subsidize debtors, the more that savers will grow discouraged. As a lifelong saver who has never had any debt I am in the minority now in lamenting this, but I guarantee that I won't be for long!

As more and more savers become discouraged like me, gradually the capital markets in the US will seize up. Private investors and savers will stop buying Treasury bonds, mortgage-backed bonds, agency securities, and corporate debt. As bond purchases fall, interest rates will be forced higher in the free markets. Why should I, or you or anyone, lend the finite and precious capital that we have worked so hard over a lifetime to accumulate when we are guaranteed to lose real purchasing power and wealth just for making our funds available to debtors?

If the Fed wants to steal from me to subsidize some goofy debtor, the heck with the Fed and the conventional capital markets! I can stay well ahead of the inflationary depredation, and earn legendary profits to boot, by shifting my capital and resources into precious metals rather than dismally low-yielding bonds or hyper-overvalued and equally dismally low-yielding stocks. And this is exactly what I have done personally and recommended that my clients do as well since this gold bull stealthily began.

See the terrible problems and bitter fruits evident here friends? Savers and investors drive economic growth. But when the Fed forces real rates negative, they deny us a fair return for our stored labor in the form of our capital savings. While we are blessed to have the capital to finance ventures to move the economy forward, what is the point in even making our capital available if we are guaranteed to lose purchasing power for putting it at risk? Aren't we supposed to actually earn money by risking our hard-earned capital?

Negative real rates squeeze the life out of conventional capital markets, discouraging savers and investors over time and ultimately retarding economic growth. And these savers and investors seek a refuge where governments cannot dictate terms to them, where their hard work and purchasing power will be preserved until sanity returns to the conventional capital markets.

So flight capital starts flowing into the precious metals, slowly at first as today or in the early 1970s, but ultimately in a great deluge that culminates in a major gold bubble as in the late 1970s and perhaps again in the coming decade sometime. When the gold bubble arrives, saver and investor confidence is so damaged by gross central-bank mismanagement that real rates have to soar to massively positive levels to entice savers back into the conventional capital markets, just as in the early 1980s.

It is so incredibly important to realize that the low-rate financial tidings that are celebrated today, like very low mortgage rates, are not one-sided transactions. Every ultra-low below-long-term-fair-market-value mortgage interest rate today outright steals from the savers and investors on the other side of this transaction. This disincentive to lend gradually dries up the pool of available capital for future investment.

Today's home "owners" who have 75%+ of "their" houses debt financed may think that they are getting a steal at nearly 50-year low interest rates, and they are. On the other side of these transactions though are savers, including many elderly folks who have busted their tails and worked hard for over four decades to painstakingly accumulate a capital surplus to finance their retirements.

These savers make a trivial nominal return even in a negative-real-rate environment, but after inflation they can buy less and less with each passing year. Many have seen their retirement incomes cut by 80% or more thanks to Greenspan's wholesale robbery of savers. It is sad and appalling, and history will curse the memory of Alan Greenspan like it does John Law. Capital markets cannot sustain such a gross disconnect between savers and debtors indefinitely.

Zooming in, the relationship between our current gold bull and the Greenspan War Against Savers is even more readily apparent. The exact same fundamental market relationships that dominated the 1970s and early 1980s remain strong to this day. It never ceases to amaze me that the Fed does not seem to be petrified about repeating the horrible 1970s, as it has been merrily on this disastrous course since it foolishly tried to reignite a failed stock bubble in early 2001.

Back in early 2000, even while the speculative mania in the stock markets soared, the capital markets were fairly healthy with a positive 3% real rate of return for savers. With 1y Treasuries yielding a bit over 6% while CPI inflation ran around 3%, savers could expect to actually increase their purchasing power year-over-year by lending their precious capital to debtors, the way that the markets are supposed to work.

It is quite interesting that the long bear market in gold continued throughout 2000 as well. Gold really didn't start stabilizing and carving a major long-term secular bottom until early 2001, soon after the US Fed began slashing short-term interest rates like there was no tomorrow in order to attempt to bailout overextended stock-market speculators. As the real rates of return finally plunged decisively below positive 1% at the end of Q1 2001, the gold bull market subtly launched.

Since then, real rates in the United States have remained under positive 1% for the most part, a terrible rate of return for savers. By early 2003 they plunged as low as negative 2%, the lowest real rate of return witnessed in America since 1980, over 20 years ago now! As I discussed in "Real Rates and Gold 5" these real rates have risen modestly in 2003, primarily due to government lowballing of the official CPI inflation numbers, but they still remain very negative and destructive for savers.

With CPI inflation reportedly running at 2% now, according to the unaccountable bureaucrats in Washington, in order to restore even a quasi-healthy positive 2% real rate of return again for American savers and investors we would have to see short-term rates utterly soar. Nominal interest rates would have to rocket up by a breathtaking 3%, from 1% to 4%, in order to see even low-end positive real returns for savers again.

To run from 100 basis points up to 400bp is a massive quadrupling of the cost of money over the short-term! In other words, to restore a more normal balance between savers and debtors, making mutually-beneficial capital transactions possible again, the Fed would have to increase the costs of borrowing money for short-term debtors by an incredible 4 times!

How likely is this to happen, at least voluntarily on the cowardly Fed's part, in the coming years? Not very! By enticing and seducing folks into taking on far more debt than any sane person should ever even consider, the Fed has created a giant economic trap. If short rates rise significantly, overextended debtors will be crushed like bugs, especially those who have debt without fixed costs such as adjustable-rate mortgages that rise with general interest rates.

So the Fed has tied its own hands and is pretty much damned if it does restore saver/debtor balance and damned if it doesn't. If it finally quits manipulating short rates artificially low, savers will gradually want to reenter the capital markets, which will grow healthier over time. But debtors will be squeezed until their eyeballs are ready to pop out of their skulls as their already overextended debt burdens are ratcheted relentlessly higher to excruciating levels by rising rates. In addition, the hyper-overvalued US stock markets would plummet if interest rates even doubled, let alone quadrupled!

But if the Fed doesn't restore saver/debtor balance through fair and mutually beneficial short rates, then savers will continue to leave the American capital markets in favor of other less hostile destinations including the mighty fortress of gold. The US dollar will continue to fall and the financial markets will grow less and less healthy until some kind of exogenous crisis shocks the system in the coming years.

The ultimate reckoning will be ugly, as it was in the early 1980s for stocks and bonds alike. Naturally gold will continue spiraling higher in such a hostile negative-real-rate environment, probably climaxing in a magnificent speculative mania bubble again sometime in the coming decade or so.

Now if the Fed had an ounce of courage amongst its bureaucrats, it would cease plundering savers to subsidize debtors today. Greenspan would publicly announce that short rates were going to at least 4%, the terribly overvalued equity markets would crash, and slowly but surely the gross speculative excesses of the mania years would work their way out of stocks, real estate, and other areas of the US economy.

But, realistically, what are the odds of such a scenario? I suspect zero. The vast majority of Americans have chosen to be poorer and have a much lower standard of living in the future by borrowing from future earnings to service debt today. Since democracies are political creatures, it is highly unlikely that the Fed would even consider doing the right thing when the US is so awash in staggering levels of debt across the board. Odds are the Fed will take the "easy" path, letting the speculative excesses continue to fester and grow until the markets force an ugly reckoning.

While this is an admittedly dim and discouraging scenario, it does have a silver lining. If the Fed is going to keep real rates artificially negative for as long as it can in the coming years, then the young Great Bull in gold and silver will only accelerate. More and more savers will grow discouraged and they will park their capital in the precious metals to protect it from debtors eroding and stealing purchasing power each year via negative real rates.

So as long as real rates in the US remain negative, one of the most powerful foundational fundamental underpinnings of this gold bull remains firmly in place. And as investors we can be pretty sure that this gold bull will continue accelerating to the upside just as it did in the 1970s in a similar era hostile to capital accumulation.

Actually, this gold bull will probably continue galloping higher until real rates shoot massively positive in the years ahead, similar to the early 1980s, in order to finally convince savers and investors worldwide that the Greenspan-War-Against-Savers madness has finally ended!

As such, we will continue to watch real rates at Zeal, analyzing them periodically. I strongly encourage all of you hardworking savers who have painstakingly lived under your incomes for decades in order to accumulate surplus capital to do the same.

Negative real rates are one of the most important ingredients for a massive bull market in gold, and the way things look now they are going to remain negative in the States for some time to come.

Rather than watching debtors steal from you, you savers will be much better off taking refuge in gold and silver. Your wealth and purchasing power will not only be preserved, but you will probably earn enormous real profits as this powerful gold bull continues soaring in the years ahead.

Adam Hamilton, CPA
email: zelotes@zealllc.com
January 30, 2004

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