Interest Rates and "The Death of Gold"
According to the Financial
Times, “the end of gold as an investment has come a little closer.” The op-ed writer reached this conclusion in a
The prospective investment
return offered by gold is an especially timely subject, now that Chairman
Greenspan has suggested that risk-free interest rates may actually begin to
rise from the current “emergency” 1% 46-year low. The unique attribute of gold is safety. Its free market price is a function of the
level of comfort investors have in financial instruments that offer an
investment yield, but are less than perfectly safe. For the first time since the secular bear
market in financial assets commenced in 2000, there is a prospect of rising
interest rates, and possibly for a “considerable period of time.” Does this mean a new world for gold?
How does gold do in a period
of rising interest rates? The casual and
perhaps superficial answer, and the one already reached by supposedly savvy
street-smart traders over the last several weeks, is that it does poorly. The recent precipitous 11% decline in gold
prices from $430 to $385 suggests that the fund managers, TV commentators and
traders dumping gold were collectively reading from the Summers-Barsky script (the
1988 thesis by former Undersecretary of the Treasury and current President of
Harvard
“The
willingness to hold the stock of gold depends on the rate of return available
on alternative assets. We assume the
alternative assets are physical capital and bonds.”
In his paper “Gold 2002: Can
the Investment Consensus Be Wrong? The
Summers Barsky Gold Thesis” Peter Palmedo of Sun Valley Gold demonstrated that
the weekly price fluctuations in gold were almost entirely (88%) explained by
the stock market. Notwithstanding the covariance of both in 2003, it is a
matter of common sense. Expectations for
good returns on financial assets put gold in the doghouse. However, losing money in stocks and bonds,
especially the expectation of more of the same, drives investors to consider
the merits of safe havens including cash, T-Bills, and gold.
The residue of high
investment expectations built up in the previous bull market, even though the
S&P remains 22% below its all time peak four years ago, occludes the merits
of safe haven investing. The survival of
optimism in the aftermath of the dot com crash is a testament to the resilience
of institutional and popular memory as well as to the inherent difficulty, at
the broadest cultural levels, of recognizing and adapting to new
realities. In addition, high hopes have
been sustained well beyond the norm by the Fed’s stance of aggressive
ease. Almost free 1% money (and the
promise of more) sustained the illusion of positive returns by allowing carry
trade artists to craft “new” investment products built on nothing more than
speculative leverage. The reflation
trade, which centered on “hard assets” of any kind, was a corollary of the Fed
stance, and explains both the speculative excess in base metals as well as the
temporary misperception of gold. It also
explains why 2003 provided an exception to the rule that gold prices tend to
vary inversely with those of financial assets.
While a rise in interest
rates might be presumed in the popular media to be theoretically bad for gold,
it is more important to ask and answer several related questions before jumping
to any particular conclusion. First, is
the prospective rise in interest rates the beginning or the end of a
process? Second, are the increases in
nominal interest rates identical to real interest rates? Third, and most important, will the interest
rate increases be favorable or adverse for the returns on financial assets?
The next interest rate
increase will, it can be stated with confidence, begin rather than complete a
process. How far must the Fed raise
interest rates before monetary policy can be considered neutral rather than
aggressively accommodative? Assuming,
for the moment, that measured price inflation is running at 1.7% (latest 12
months), most would put a “neutral” Fed Funds rate at +/- 4%. Should measured inflation begin to rise, as
it did most emphatically in the most recent Consumer Price Index (CPI) report
and as it is doing on an anecdotal basis almost everywhere, to what level would
short-term rates have to rise in order to be considered restrictive? Almost certainly, that number would be
substantially above 4%. It does not seem
far-fetched to suggest, considering the level of existing and prospective
budget deficits, the unprecedented build up of debt, the open-ended nature of
American military commitments, and the disinclination among political leaders
to restructure Medicare and Social Security entitlements, that the year 2004
bears a strong resemblance to 1968. In
that year, the DJII peaked at 1,000, a level it would not exceed until
1982. The Fed Funds rate was 5.66% in
1968 and rose to 16.39% in 1981. Returns
on financial assets were poor during those 14 years. Gold and gold shares, on the other hand,
turned in stellar performance.
The 1970’s, for those of us
who were around to enjoy them, do not conjure up happy associations when it
comes to investing. The decade began
with the demise of investment managers who had posted the gaudiest returns in
the late 1960’s, the “three Freds,” Mates, Carr and
Alger. The bond market was sound asleep, as detailed by Grant’s “Where We Came
In” (
The entrenchment of mistrust
depends on deception, both externally applied and self-induced. In due course, history will reveal multiple
deceptions at the core of the current bear market. In the 1970’s, a short list would include the
Watergate scandal, failure to communicate the war-time realities of
A core deception of the
moment is the notion that a few up ticks of 25 to 50 basis points in short term
rates will be sufficient to arrest the forces of inflation set in motion by the
most aggressively accommodative Federal Reserve in history. Real interest rates, defined as the 90 day
T-bill discount rate less trailing twelve months inflation, are negative by approximately
100 basis points (see chart below). This
is, no doubt, a very gold-friendly statistic.
A few hundred basis points of rate increases over the next twelve to
eighteen months raises the possibility that this
measure will no longer be so friendly.
On the other hand, if measured inflation rises in lock step with the
rate increases, the environment will remain positive for gold.
To predict real interest
rates 18 months hence would require insight unavailable to most mortals and
certainly to this writer. There are two
components to the equation. Variable A
is the future trailing twelve-month rate of inflation. The CPI “run rate” is 6%. Future CPI releases will be closely watched
to see if inflation maintains the torrid pace suggested by recent data. Variable B lacks the apparent exactitude of
the first. It is the measure of
aggressiveness yet to be employed by the Federal Reserve Board in countering
the incipient inflationary threat. Will
it be ruthlessly Volcker-like, administering interest rate medicine so strong
that the economy grinds to a halt, or will it continue to be Greenspan-like in
staying behind the curve in order to not to shatter the eggshell pyramid of
debt grounded upon the Fed’s easy stance?
While we have our own ideas on this matter, the behavior of the gold
price in future months will provide the necessary illumination.
This analytical exercise is
complicated by the fact that the CPI, a statistic revered by CNBC, brokerage
house economists, and most of the investment community emits a signal that is
profoundly less clear than its 1970’s antecedent. Hedonic adjustments are applied to 50% of the
item prices measured in the index. Hedonics is the science of adjusting product
prices for qualitative improvements enabled by technology. Nearly all of these adjustments result in
lower rather than higher price measurements.
(For more, see The Real Value of the Dollar) The current version of the CPI also
incorporates “Owners Equivalent Rent,” which standardizes all housing costs on
the notional rent that a homeowner would pay for similar housing quarters. Although the Office of Federal Housing
Enterprise Oversight measures the 2003 increase in housing prices at 7.97% (and
the 4th quarter at 14.67% annualized), the Bureau of Labor
Statistics figures that the housing component of the CPI has been advancing at
only 2%, thanks in large part to the adjustment for Owners Equivalent
Rent.
Will the financial market
add the missing 200-300 basis points back to the CPI in calculating the real
interest rate? Our guess is that it will
not. Understatement of inflation by the CPI will ultimately disenchant
investment expectations. An inaccurate
read on inflation will justify prolonged monetary ease. A continuation or widening of the present
disparity between nominal and real interest rates is an important premise for a
commitment to gold.
Finally, what collateral
damage would arise from a multi-year rise in interest rates sufficient to quell
gathering inflation? The policy choice
will come down to whether it is preferable for the
The gabby Greenspan Fed has
failed to communicate to those offside in junk bonds, overpriced equities,
interest rate swaps, emerging market sovereign debt, and all other unfathomable
reaches of the carry trade of the stark choice between tolerating a further
buildup in inflation or aggressive rate increases that would choke the economy
and collapse the carry trade. To preempt
inflation fostered by four years of aggressive ease, the Fed must drive a
sustained and politically untenable rise in real interest rates. Rate increases cannot be tepid or token. Once
inflation becomes entrenched in the industrial economy, financial structure,
and public expectations, it is notoriously difficult to root out. The longer the Fed waits, the more severe the
market pain. The Fed’s policy dilemma
contains the seeds of a prolonged bear market in financial assets. The unwillingness of political leadership to
address the fiscal issues surrounding the open-ended financial aspects of
terrorism in conjunction with generous entitlement programs is a recipe for
expanding debt issuance, which the Fed will be called upon to accommodate. The Fed may continue to bark but it cannot bite.
Anyone who thinks that the
recent slaughter of speculative longs in the gold market is an isolated event
may wish to revisit their conclusion. It
was a mini version of the Asian Meltdown, the ’87 crash, LTCM, and the dot-com
bust. It was one more misadventure of
hot money. The mere inkling that
interest rates might rise was a lethal pinprick to the hard asset investment
bubble, which had co-opted gold. The prospect of higher rates also helped to
strengthen the dollar versus the euro, adding further impetus to gold’s sell
off. The debacle was the work of an
imaginary rate increase on a tiny sliver of the capital markets. Damage to a far broader range of financial
assets will occur when the inexorable rise in rates actually begins. In such a context, gold’s ability to protect
capital will become widely appreciated.
Fear of collateral damage to
financial assets has weighed on Fed thinking for several years. In the
“I
believe that the stock market decline has had a very profound effect, and
indeed one can argue that a goodly part of the increased risk aversion is
itself a consequence of the collapse in stock market values…so, in one sense
differentiating equity markets and the credit markets is not something that is
very meaningful because both very much reflect the same underlying process of
pulling back….the approximately $3 trillion capital loss in the aggregate value
of equities in the United States, most of which are held by U.S. residents,
just cannot be occurring without considerable breakage of crockery somewhere.”
Greenspan correctly observed
that there is a seamless linkage between credit and the stock market. He goes on to say that this represents a
fundamental change from 30 years ago because “the aggregate size of stock
holdings relative to income is so much higher now and so many more people have
equity investments that the effects of stock market declines on economic
choices is almost surely higher.” A protracted decline in the equity markets,
in the mind of Fed (and correctly so) would be a credit contraction by any
other name.
Gold is without question a
seasonal investment. Decades can slip by
while gold slumbers, or worse. However,
during extended credit contractions, when lenders and investors alike shy away
from risk, credit spreads widen and safety becomes paramount. In the rainy seasons of the 1930’s and the
1970’s, gold rose against financial assets.
It did so not because it was part of some “reflation cocktail” dreamed
up and packaged by promotional investors.
It did so because a general movement towards safety caused by adverse
experience in financial assets investments bid up its price.
While monetary and fiscal
policy can be temporarily marshaled to counter a market-initiated credit
contraction, as has been done with some success since 2000, such intervention
can only delay market forces. Worse, the
cost of overriding such forces only increases the potential damage from a
contraction. For example, does anyone
think that the safety of leveraged closed end funds peddled to satiate the
public’s appetite for yield in a 1% interest rate environment is more than
illusory? The narrowing of credit spreads since the Enron blowup (see above
chart) reflects not a more sanguine assessment of general credit conditions but
rather the success of the investment community in promoting junk to satisfy
the desperate scramble for yield. According
to David Hale (
“During
the last twelve months the total return on emerging market C rated debt has
been 34.5% compared to 6% on A rated securities…The share of triple C borrowers
in the U.S. high yield market rose to 23% during the past few months, or the
highest level ever recorded.”
The reflation trade has been
a truly reckless game. It depended on
the inconsistent rationale of 1% money, Fed largesse forever, and the prospect
of synchronized non-inflationary global growth.
Now that inflation is knocking on the door, the Fed has been forced to
blow the whistle. However, it cannot go
beyond issuing warnings without sabotaging investors and borrowers alike who
cannot tolerate the portfolio markdowns or cost increases that a restrictive
stance would imply.
Richard Russell, veteran
market analyst, harbors no doubt that we are in the early days of a protracted
bear market: “First, what’s happening--and
I’m not talking about markets, I’m talking about fundamentals. I’ve been talking about the monster edifice
of debts in the US--debts in the cities, the counties, the states, the
corporations--consumer debt, mortgage debt, credit card debt, you name it,
anywhere you look all you see is debt.
The nation is up to its eyeballs in debt” (Dow Theory Letter
To time the tipping point
between inflation and deflation, as with calling the top for the dot com mania,
seems futile. What is clear, however, is that the fear of deflationary outcomes
begets inflationary policy responses, as Fed Governor Bernanke has so
forcefully stated over the last few years. While there can be no doubt that the
end game is deflationary, an inflationary episode or two may occur along the
way. For gold, it makes little
difference because either prospect erodes confidence in financial assets.
“Investors continue to buy
into the notion that this or that government official can pull a few levers and
make things right again,” says David Lewis, a former New York FX options
trader. There is an unstated assumption
that economic outcomes can be achieved through adherence information known only
to a small circle of practitioners. The
proper examination of arcane data somehow yields clues as to whether or not to
raise interest rates. The totality of
capacity utilization rates, unemployment claims, PPI, CPI, the
As for the Financial Times’
observation that gold is a risky investment because it offers little or no
return, we agree in part. However, the
risk in gold is not the inherent lack of return. The risk is whether holding a position is
timely or not. There is little to
analyze about gold itself. It is what it
is--inert, mute, and passive. Unlike stocks or bonds, there is no internal
compounding or coupon. However, there is
much to analyze about whether investors will eventually find gold to be
attractive or otherwise.
We were cheered by the
recent FT disparagement of gold. It
reminded us of an FT opus entitled “The Death of Gold” published
The views
expressed by the portfolio manager in this article are current as of the date
of this article, and are subject to change at any time based on market and
other considerations.
John Hathaway
May 5, 2004
© Tocqueville Asset Management L.P.
New York, NY 10019