Real Rates, Gold & the ‘know nothing’ Fed – ADRIAN ASH

Sep 18, 2014 - 4:00 PM GMT
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Gold’s descent to its lowest since the end of January does not make a strong case for short-term profit seekers.

This year’s 17-percent rise to the middle of March and the eight-percent rise in June now look like a bull trap to technical traders, a sucker’s rally that pulled in new money only for the slump starting at the September 2011 peak of $1,920 to resume.

Silver looks worse again, trading near four-year lows beneath $18.70 per ounce. So plenty of internet pundits, in contrast, will surely claim this drop was engineered to mask runaway inflation in the cost of living – i.e. a continued loss in the value of money.

Derivatives traders have indeed thrown a mountain of bearish bets into the precious metals market.  But it is now ‘speculative’ money managers, rather than ‘commercial’ traders from bullion banks, who hold their largest short position against gold on record. And whatever your experience says of rising prices and shrink-flation, the bond market also thinks inflation is receding.

US inflation-linked bond yields have risen, analyst Walter de Wet at Standard Bank has noted, and the yield on five-year inflation-linked bonds “represents the five-year average real interest rate”.

Put another way, expectations for the real rate of interest – meaning the interest rate after accounting for inflation – has risen. And that is classically bad for gold investment or, at least, for perceptions of gold’s investment outlook.

History says there is no constant relationship between gold prices and nominal rates. Indeed, gold prices and the Fed Funds rate have moved in opposite directions only half the time over the last 45 years, rising or falling in tandem in the other half.

But looking at the real rate of interest, accounting for inflation, real gold prices (again, accounting for inflation) tend to rise much faster when real rates fall. Since 1969, gold’s annual gains have averaged nearly 10 percent  above US inflation when real rates fell compared with only 2.5 percent during periods when real rates were higher from 12 months previously.

For gold investors today, the question isn’t so much whether or when the Fed might raise rates but whether it would dare to raise rates faster than any pick-up in inflation.

Why? Other things being equal, rising real rates dissuade big money managers from buying or holding gold. Whether they are right or wrong does not matter to prices in the short term. They make the running – the size of the speculative long position, minus that group’s bearish bets, shows a strongly positive correlation with gold prices, averaging 0.8 on all one-month periods over the past five years. Higher real rates mean a bigger opportunity cost for money managers choosing zero-yielding gold instead of cash or bonds.

“[But] the decline in the inflation-linked bond yield seems to be driven by lower inflation expectations,” de Wet said, comparing what is happening with inflation-linked bonds against conventional five-year Treasury debt. And we know that, as in the eurozone, the US central bank takes the threat of inflation’s evil twin – price deflation – very seriously. Inflation in US consumer prices was last pegged at two percent per year, at the Federal Reserve’s target level. But lower expectations – plus the rising dollar, depression in the eurozone and China’s historic over-capacity – clearly put the risk of US deflation back on the table. Quantitative easing has not quite finished. The Fed’s commitment to using it goes without question. Today’s rising real rates alongside gold back below $1,250 suggest that commitment may be called upon again very soon because deflation will not be tolerated.

But the political – and internal – short-term pressure on the Fed to taper the last $25 billion of its monthly QE cannot be ignored. Lambasted from all sides for inflating the stock market to new record highs with money-from-nowhere, the Fed has long said it will raise interest rates in 2015 as well but that “sometime distant” is getting close.

Ending QE this autumn and then lifting rates in the New Year would show who is in control – or so Janet Yellen’s committee might feel. But tightening US liquidity so firmly when two of the world’s three leading economies are flirting with a major contraction would surely risk the kind of blame thrown at the Fed over the 1930s Great Depression, never mind its more recent role in the post-Lehman meltdown of 2008.

At the very least, it would smack of the European Central Bank’s infamous rate rises in summer 2007 – just as the Western banking crisis blew up – and again in summer 2011 just as the crisis peaked in the US and morphed into the eurozone’s own sovereign debt panic.

A soft landing for US policy might well damage gold’s appeal to money managers further as the real rate of interest ticks higher. Gold prices failed to shoot higher when the Fed last raised the pace of its QE to $85 billion per month in December 2012.

Equities were then at their best since before the financial crisis really got started so the end of 2012 was where gold and the stock market diverged, leading to a 35-percent drop in bullion as tapering approached and kicked in while the S& set fresh all-time highs

But a sudden loss of dollar largesse in 2015? Coupled with today’s four-year lows in commodity markets and confusing inflation data at best – perhaps even signalling wider deflation – the Fed will risk sparking panic in foreign bonds and equities. Ironically, that could wash back into US markets.

But a surging dollar and sinking equities were what sparked the outsized mea culpa from the Fed after it saved AIG’s creditors but let Lehman go to the wall eight years ago.

Gold prices initially fell hard late in 2008 as credit fled the futures market – the net speculative long position shrank 70 percent between July and November that year. Physical demand among investors both retail and ‘smart’ surged, however, even as US consumer prices tipped into deflation because sometimes real rates matter less than credit risk. Aggressive inflation from the US Fed only makes buying gold more urgent still.

Adrian Ash is head of research at BullionVault, the physical gold and silver exchange for private investors online.