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
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
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
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
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
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
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
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
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
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.
rallying strongly and real rates probably already negative in reality, it
will be interesting (pun intended) watching how it all plays out.
June 21, 2002
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