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Inflation Fear

Real Interest Rates and Gold

Written by Christian DeHaemer
Posted May 28, 2013

After reading the tea leaves and looking at the entrails of a white calf over the long weekend, it looks to me like the gold sell-off is overdone.

No one knows why gold got crushed over the past year, but it has sold off about 30%.

There is a lot of speculation regarding margin calls. Or perhaps a hedge fund blew up. Some gold bugs see conspiracies in central banks to push down inflation worries.

I don't think we will ever know...

But if you look at the chart, it doesn't take much speculation to see that it's gone too far, too fast:

gold may 28

As you can see, we have put in a double bottom.

That large volume spike a month ago is a capitulation low. This is when everyone was getting out. The second bottom is value buyers getting in on the low.

We also have a MACD crossover, and we are well below the 50-day moving average.

Reversal to the mean would suggest we have 15% short-term upside at this point.

Look for gold to fill the gap at $1,490 an ounce.

And there are several reasons beyond the technicals to speculate that gold will go up from here...

Golden Idea

  • The Chinese and Indians have been buying record amounts of gold (though there was a slowdown this week); and

  • There is the onslaught of future inflation due to central bank printing and the global destruction of currencies.

According to MSN Money:

The four largest central banks are abusing their currencies as fast as they can, with Japan going for broke with the "cheap money will save us" meme while the European Central Bank cut rates earlier this month for the first time since the middle of 2012.

And in just the past month, smaller central banks have begun joining in with gusto. Australia cut rates to record lows. Denmark cut rates. India cut. Turkey cut. South Korea cut. Israel cut. Kenya, Belarus, Poland, Georgia and Sri Lanka also cut.

But the number one reason the gold bull market will continue is a rule so simple, a five-year-old could understand it — and yet very few people know about it.

Not only that, but when this secret signal reverses, it provides a clear sell signal as well. It's just like ringing a bell at the top.

But we aren't there yet. Not even close.

The secret?

The price of gold has everything to do with Real Interest Rates (RIR).

Real Interest Rates

There is only one reason the smart money buys gold, and that's because you can't make any money from bonds.

Bill Gross, the world's largest bond holder, recently put out this tweet: “The secular 30-yr bull market in bonds likely ended 4/29/2013. PIMCO can help you navigate a likely lower return 2-3% future.”

The price of gold is directly linked to Real Interest Rates (RIR). RIR is the nominal interest rate minus the inflation rate.

Currently, the 30-year Treasury is 3.18%. The ten-year is 2.01%. The one-year is 0.12%, which is almost nothing. The current CPI is at 1.7%, minus food and energy.

Using the one-year Treasury, we are in a negative interest rate environment.

It could be the sell-off in gold over the past few months can be explained by speculation that the Fed and other central banks will stop giving away free money. But this seems premature at best.

As you can see by this historical chart, when RIRs are negative, gold goes up. Simple.


Just to review, the definition of RIR is an interest rate that has been adjusted to remove the effects of inflation. This reveals the true yield to the lender.

The RIR of an investment is calculated as the amount by which the nominal interest rate is higher than the inflation rate.

In other words, if you are getting 5% interest from a T-bill and inflation is at 10%, the real rate of return for your money is -5%. You just lost money in terms of purchasing power.

The Smart Money

The smart investor can only conclude that until the bond market has a positive rate of return, there is no reason to own bonds.

These same investors know that owning gold during times of negative bond returns can be extremely profitable...

In the 1970s, during a similar situation, the price of gold went up more than 1,832%, while inflation went up 105%. Since 2001, gold is up 560%, while inflation is up about 30%.

The opposite is also true: When real interest rates are positive, as they were from 1982 to 2000, gold sold off in an unrelenting bear market.

What's Next?

As we have determined, the long-term gold market is determined by real interest rates.

Where do they go next?

Ben Bernanke at the Federal Reserve has said they will keep rates low and print $85 billion a month until the labor market improves, or the economy gets going. And the Fed has stated it will keep buying bonds to keep rates low “at least until mid-2015.”

I see no reason not to believe them.

Housing Inflation

Over the past five years, we've been in an deflationary environment. The price of housing and labor decreased.

But those trends seem to be changing...

Today's Case-Shiller home price index came out for March. It showed housing prices were up 10.9% in the 20 market index. And unemployment is down to 7.5%, help wanted ads are up, and the labor force participation rate is looking to bounce off its trend line.

A rise in inflation will force the Fed to raise rates.

But it does not change the facts for real interest rates...

The Fed always hikes rates too slowly for fear of stepping on the brakes and killing off the economy. It is easy to imagine a scenario where inflation quickly gets ahead of the Fed rate. This is what caused the booming gold market in the 1970s.

Short term, it looks like gold will get a dead cat bounce.

Longer term, we need to keep a weather eye on inflation versus Treasuries.

Until next time,

Christian DeHaemer Signature

Christian DeHaemer

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Since 1995, Christian DeHaemer has specialized in frontier market opportunities. He has traveled extensively and invested in places as varied as Cuba, Mongolia, and Kenya. Chris believes the best way to make money is to get there first with the most. Christian is the founder of Bull and Bust Report and an editor at Energy and Capital. For more on Christian, see his editor's page.

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