Gold, Inflation & Interest Rates - 23 June 2010
HOW COME GOLD keeps reaching and breaching new all-time highs in the absence of strong 1970s-style inflation?
The Buttonwood column in last weekend's Economist is only the latest analysis to miss the point, despite tripping over it, too.
"Owning gold is traditionally seen as offering protection against inflation. And inflation is very bad news for owners of government bonds.Ay, there's the rub, as we never tire of telling people here at BullionVault. They tire so quickly of hearing it, however, that even The Economist can't square the circle of rising gold, falling bond yields.
"But the ten-year Treasury bond yields just 3.3%, a level that is towards the low end of the historical range...You would expect the performance of gold and Treasury bonds to be inversely correlated. When gold was at its real all-time high in 1980, the ten-year Treasury-bond yield was 10.8%. Fixed-income investors had suffered years of negative real returns in the 1970s."
But it was never inflation alone that drove people to buy or sell a lump of rare, indestructible metal in the '70s. Instead, it was rather the rate of return offered by cash and bonds – those better competitors as a store of wealth, all things being equal – over and above (or below) inflation.
That's why gold made a terrible inflation hedge in the 1980s and '90s, most especially for Dollar investors. Because no-one needed an inflation hedge. Not with 10-year Treasuries paying 4.3% average over and above CPI inflation. Not when the real Fed Funds rate averaged 3%-plus...leaving gold to drop three-quarters of its real Dollar value inside 20 years...as the real value of cash-on-deposit doubled.
Now compare and contrast with the last eight-and-a-half years or so, starting right around the Fed's low-rate response to the DotCom Bust. Consumer price inflation (on the official US measure, at least) has averaged barely half its previous two-decade average. Yet the real returns paid to bonds and cash have collapsed. Adjusted for inflation, in fact, the real Fed Funds rate has now been below zero for 54 of the last 101 months, matching the 54 months of sub-zero real rates which the Fed delivered in the 1970s.
Things are worse still, however, for cash savers. First because the Seventies' 54 months of negative real rates were spread across 10 full years from Jan. 1970. Meaning that second, the overall effect on the average real rate since 2002 has been to drive it lower again.
During the 1970s as a whole, the Federal Reserve's key interest rate was 0.01% above inflation. Since 2002, the average real rate has now been 0.12% below.
Where next? Short of a revolution in Fed thinking (no sign of that today), the decade starting Jan. 2002 looks set to deliver yet more negative real rates before 2012, if not beyond. Which will continue to mean that:
- Holding cash-on-deposit guarantees a loss of real value, something that even the most passive, cautious savers will only put up with for so long;
- The opportunity cost of holding gold or silver – the foregone interest you'd otherwise receive on cash – remains absent.
Because when "risk free" cash keeps paying a guaranteed loss, then a growing number of people will, in due course, start seeking shelter elsewhere. At the same time, holding gold and/or silver has ceased being a burden (bullion storage fees need not be onerous), inviting fresh flows of retained capital, tired of earning nothing or less.
Real returns to cash have now been low-to-negative for almost a decade, and so it might not be too long before a far broader, and thus larger, volume of savings turns from cash to the obvious and historic alternatives. Either that or the Fed will hike rates so high, you get 4% and more above inflation.
Adrian Ash runs the research desk at BullionVault, the physical gold and silver market for private investors online. Formerly head of editorial at London's top publisher of private-investment advice, Adrian Ash was City correspondent for The Daily Reckoning from 2003 to 2008, and is now a regular contributor to many leading analysis sites including Forbes and a regular guest on BBC national and international radio and television news. Adrian's views on the gold market have been sought by the Financial Times and Economist magazine in London; CNBC, Bloomberg and TheStreet.com in New York; Germany's Der Stern and FT Deutschland; Italy's Il Sole 24 Ore, and many other respected finance publications.