Gold and Interest Rates
We've devoted a lot of space to this topic in commentaries over the past few months, but it's very important and warrants another visit at this time.
The expected inflation rate is one of the most important drivers of the gold price, but because we are talking about an expectation it can't be measured in the way that, say, historical changes in money supply and prices can be measured. Instead, all we can do is make assumptions about the expected inflation rate based on what is happening in the financial markets. For example, if the yield-spread is widening, that is, if inflation-sensitive long-term rates are rising RELATIVE to less-inflation-sensitive short-term rates, then it might be reasonable to assume that inflation expectations are rising. This would particularly be the case if other markets -- the gold and currency markets, for instance -- were confirming the message of the yield-spread.
Further to the above, a key point that we've tried to make over the past few months and also at many other times over the past 3 years is that the absolute levels of nominal interest rates in the US don't really matter as far as the US$ gold price is concerned (it's possible for the gold price to trend in either direction concurrently with rising or falling interest rates). What do matter are the performance of long-term rates in the US relative to short-term rates in the US (the yield-spread) and what is happening with real interest rates in the US relative to real interest rates in other countries (keeping in mind Fisher's Law, which states that the real interest rate is the nominal interest rate minus the EXPECTED inflation rate). In fact, if all else is equal then a rise in the expected inflation rate in the US will cause the yield-spread to widen, the real interest rate to fall, the gold price to rise and the US dollar's exchange value to fall, whereas a fall in the expected inflation rate would have the opposite effect.
Over the past few years we've regularly included charts at TSI to illustrate the tendency of gold stocks to move in the SAME direction as the yield-spread, but now we are going to take a slightly different tack by including, below, a chart to illustrate the tendency of the Dollar Index to move in the OPPOSITE direction to the yield-spread. Notice, in particular, that once the yield-spread turned higher during the final quarter of 2000 the Dollar Index effectively hit a brick wall, although it didn't begin to decline in earnest until 5 quarters later.
The above chart's message is that the US$ will strengthen if short-term interest rates in the US trend higher relative to long-term interest rates, regardless of whether the absolute levels of US interest rates are moving higher or lower. So, what is the probability of there being a multi-year contraction in the US yield-spread?
In our opinion, almost zero. US debt levels are at unprecedented highs and whatever economic rebound has occurred over the past 12 months has been mostly an illusion created by inflation. Therefore, apart from the occasional brief (3-12 month) interlude the Fed is likely to do whatever it has to do to maintain a sizeable yield-spread until the point is reached where inflation is widely perceived to be a much bigger threat to the system than deflation. And that point isn't likely to be reached until the gold price is well into 4 digits.
The US Stock Market - Opinions versus Facts
Almost everyone has an opinion on how the stock market is going to perform over the next few years. Our opinion is that stock prices are headed substantially lower in REAL terms; in other words, that the senior stock indices are going to move much lower when measured in ounces of gold. As is always the case, though, other analysts will have different opinions. This is the way it must be because in order for the market in stocks to exist there must be people who expect prices to move higher and people who expect prices to drop.
Forecasts are, by definition, opinions, but some forecasts have a better chance than others of coming to fruition because they are based on factual evidence. The following, for example, are facts:
1. Throughout history, once the average price/earnings ratio of the US stock market has reached a major peak and turned lower it has continued to move lower until it has fallen below 10.
2. With the exception of the 'bubble years' of the 1990s, a P/E ratio of 22 for the S&P500 Index (the current level) has invariably occurred at around the time the market was close to an important peak.
3. Long-term trends in the stock market are driven primarily by changes in the amount that investors are willing to pay for a dollar of earnings, not by changes in earnings or earnings growth rates.
Further to the above, a stock market forecast that calls for good inflation-adjusted returns over the next several years is saying, in effect, that the P/E ratio of 40 achieved by the S&P500 Index earlier this decade was not the ultimate peak for valuations OR that the long-term cycle in valuation that has governed the stock market throughout its history no longer applies. This is a forecast we would confidently bet against.
16 July, 2004
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