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This week's downside
breakout in the T-Bond futures market and the associated rise in the T-Bond
yield has prompted us to re-visit the relationship
between gold and interest rates. In the process of doing so we'll address the
question: are rising interest rates bullish or bearish for gold?
We'll begin
by noting what happened to nominal interest rates during the long-term gold
bull markets of the past 100 years. Interest rates generally trended downward
during the gold bull market of the 1930s, upward during the gold bull market
of the 1960s and 1970s, and downward during the first 10 years of the current
bull market. Therefore, history's message is that the trend in the nominal
interest rate does NOT determine gold's long-term price trend.
History tells
us that gold bull markets can unfold in parallel with rising or falling
nominal interest rates, but this shouldn't be interpreted as meaning that
interest rates don't affect whether gold is in a bullish or bearish trend.
The long-term trend in the nominal interest rate is not critical; but what is
of great importance, as far as the gold market is concerned, is the REAL
interest rate. Specifically, low/falling real interest rates are bullish for
gold and high/rising real interest rates are bearish. For example, when gold was
making huge gains during the 1970s in parallel with high/rising nominal
interest rates, real interest rates were generally low. This is because gains
in inflation expectations were matching, or exceeding, gains in nominal
interest rates (the real interest rate is the nominal interest rate minus the
EXPECTED rate of currency depreciation). Also, the first decade in gold's
current bull market occurred in parallel with generally low real interest
rates.
Very low real
interest rates are artifacts of central banks. In the US, for example, the
Fed's actions ensured that the real short-term interest rate on "risk
free" (meaning: no direct default risk) debt spent a lot of time in
negative territory over the past ten years. It was a similar story in the US
during the 1970s. Also, despite a few "baby steps" towards tighter
monetary policy, real interest rates in China are presently well below zero
thanks to the People's Bank of China having simultaneously pegged nominal
interest rates at low levels and rapidly increased the money supply. In other
words, "very low real interest rates" means "excessively loose
monetary policy". Excessively loose monetary policy will likely be with
us for a quite a while.
Something
else that affects gold's price trend is the DIFFERENCE between long-term and
short-term interest rates (the yield-spread, or yield curve), with a rising
yield-spread ('steepening' yield curve) being bullish for gold and a falling
yield-spread (flattening yield curve) being bearish. It works this way because
a rising trend in long-term interest rates relative to short-term interest
rates generally indicates either falling market liquidity (associated with
increasing risk aversion and a flight to safety) or rising inflation
expectations, both of which are bullish for gold.
As is the
case with the real interest rate, under the current monetary system the
yield-spread tends to be a symptom of what central banks are doing. If money
were sound and free of central bank manipulation then the yield-spread would spend
most of its time near zero (the yield curve would be almost horizontal) and
would experience only minor fluctuations, but thanks to the attempts by
central banks to 'stabilise' the markets the
yield-spread experiences huge swings. Today's large US yield-spread, for
example, is due to the Fed exerting irresistible downward pressure at the
short end of the curve while the discounting by the market of currency
depreciation risk causes interest rates at the long end to be 'sticky'.
Last but not
least, gold is influenced by the economy-wide trend in credit spreads (the
differences between interest rates on high-quality and low-quality debt
securities). Gold, a traditional haven in times of trouble, tends to do
relatively well when credit spreads are widening and relatively poorly when
credit spreads are contracting.
In summary,
gold benefits from low real interest rates, an increasing yield-spread (a
steepening yield curve), and widening credit spreads, each of which can occur
when nominal interest rates are rising or falling.
If the three
main interest-rate drivers (the real interest rate, the yield-spread and
credit spreads) are gold-bullish then there's a high probability that gold
will be in a strong upward trend in terms of all currencies and most commodities.
By the same token, if the three main interest-rate drivers are gold-bearish
then there's a high probability that gold will be in a strong downward trend
in both nominal and real terms. However, it's not uncommon for the
interest-rate conditions to be mixed. The past three years is a good example
of a mixed interest-rate backdrop for gold in that during this period the
real interest rate and the yield-spread were generally gold-bullish, whereas
the credit-spread situation was generally gold-bearish. The result was that
gold fared well in terms of US dollars, but traded sideways relative to
industrial metals.
The interest
rate backdrop hasn't become any less bullish for gold as a result of this
week's downside breakout in the T-Bond and the associated rise in long-term
interest rates, but the sharp decline in the gold price on 13th and 14th of
March was almost certainly related to what was happening in the bond market.
It seems that some speculators have exited long positions or initiated short
positions in gold based on the belief that a substantial upward trend in the
REAL interest rate has just begun. This belief is unfounded, because
sustaining the illusions that the US economy is recovering and that the US
government can make good on its debt requires that
the real interest rate be kept in negative territory.
A higher real
interest rate would actually help the US economy by precipitating a proper
cleansing process involving the liquidation of all bad investments and
insolvent corporations. However, anyone who has been paying attention over
the past few years would realize that monetary policymakers in the US, as
well as in Japan, Europe and the UK, are committed to doing whatever it takes
to avoid such a process. The goal is to make the economic situation as
painless as possible in the short run, regardless of the negative longer-term
consequences.
This goal
isn't going to change anytime soon, which means that a negative real interest
rate is here to stay and that this week's drop in the gold price is just
another blip in the long-term bull market.
Steve Saville
www.speculative-investor.com
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