Today's Interest Rates are Unreal!

By: Michael_Pento

I'm often asked the question if rising interest rates will cause downward pressure on gold prices. The answer is yes, but only if those rates are rising in real terms and not in nominal terms only. But an even more important question that needs to be asked is whether or not the Fed will be able to allow rates to rise to a level that provides the market with a positive real return. The answer, unfortunately, is no.

The average gold price increased from $41.09 an ounce in 1971 to $612.29 per ounce in 1980. During that same time frame, the constant rate on the 10-year note increased from 6.16% to 11.46%. But it was not until 1981 that the average yearly price of gold began to retreat. Its average price for that year fell to $458.48, as the interest rate on the 10-year note continued rising to a record high of 13.91%!

It took ten years of steady increases in interest rates before the price of gold started to decline because it was not until then that investors in the Treasury market began to receive something close to a real return on their invested dollars. According to official Consumer Price Inflation data, the rate of inflation which began in the early part of that decade at 3%, then rose all the way to the low double digits in the middle of the ‘70's, ultimately peaking at 15% in 1980.

Clearly, then, interest rates on government debt securities can appreciate without causing the price of gold to fall because one of the most important factors driving the price of gold is the real rate of return available on Treasuries.

Today there is only a nascent rise in 10 year yields from their low of 2.08% reached on December 18 th 2008, to today's yield of 2.70%. The trenchant difference from 29 years ago is not only the relatively small increase in yield, but that the rise in yield is not the result of a rising Fed Funds rate.

The price of gold began its descent in 1980 from its then record high of $875 per ounce. However, it was during that same time period that the Fed Funds rate went from 4.5% in early 1971 to its all time high of its target between 19-20% reached in early 1981. But today we see this small rise in yield comes without even the slightest hint of an inflation-fighting rate increase from the Fed.

A flat or inverted yield curve exists only when the Fed is aggressively selling Treasuries in order to absorb excess liquidity. This causes rates on the short end of the curve to rise to levels that are at or above those on the long end of the yield curve. In contrast, today Ben Bernanke is buying massive amounts of bank debt in order to keep interest rates low. However, this inflationary practice is causing the long end of the curve to rise as the free market is trying to provide investors with a positive yield.

Regardless of what the Fed does, however, the point is made clear from the current bull market in gold; the yield provided from government fixed income instruments is still below what investors expect the rate of inflation to be.

But here is the unique problem facing the Fed this time. Unlike the Volker Fed—who crushed inflation with unprecedented hikes in the Fed Funds rate—Mr. Bernanke may find it nearly impossible to raise rates without causing massive economic carnage. The reason is clear: the level of debt outstanding in both a public and private sectors has increased to the point where servicing it becomes impossible without artificially-induced low interest rates.

In the first quarter of 1980, the household financial obligation ratio—a measure of household debt service as a percentage of disposable income--was 15.9%. It is now over 19%. As bad as today's number is, it pales in comparison to the level of consumer debt as a percentage of GDP, which is now nearly 100% of total output. Back in the early ‘80's, by contrast, it was just over 50%. On the public sector level the numbers are just as grim. National debt as a percentage of GDP has now reached 85% of output, while in 1980 it was a mere 40%.

Just imagine the stress on the consumer and the government that would be experienced if the Fed were to raise rates aggressively, as Volcker did. How could the consumer continue to service his or her mortgage and how could the U.S. Treasury finance the titanic national debt if rates were to increase much above today's levels?

The problem with inflation is real. The Fed Funds rate is currently at an historic low of 0-.25%. Meanwhile, the increase in the monetary base (high powered money) is unprecedented in history and now stands at nearly $2 trillion dollars, up from just $850 billion in September of 2008. The rate of increase is now over 300% annually. The monetary aggregates (M1, M2, M3 and MZM) have increased by double digit rates on a year-over- year basis and the fiscal 2009 deficit should eclipse $2 trillion for the first time in U.S. history.

This level of debt should lead to an even further expansion of the money supply and cause the rate of inflation to increase significantly. Yet, as the free market demands rates to rise, they must be kept under wrap by an intervening Central Bank that is forced into printing money to keep them low.

But creating inflation in order to keep interest rates low is a diametrically opposing force that cannot coexist for any extended period of time. On the losing side will be government, as free market forces will ultimately prevail in the long run.

So not only can gold appreciate in a rising rate environment, it now seems clear that any increase in rates is a long way off (if the Fed has its way). Thus, the only two bull markets that exist at this juncture are gold and U.S. debt, a condition that cannot last for long either. Investors who believe in the free market have to believe that one of those assets is in a bubble and that one is undervalued, perhaps dramatically so.

Figuring out which one is which seems simple enough to this observer.

Be sure to listen in on my Mid-Week Reality Check

Michael Pento
Senior Market Strategist
Delta Global Advisors
800-485-1220
mpento@deltaga.com
www.deltaga.com

With more than 16 years of industry experience, Michael Pento acts as senior market strategist for Delta Global Advisors and is a contributing writer for GreenFaucet.com . He is a well-established specialist in the Austrian School of economic theory and a regular guest on CNBC and other national media outlets. Mr. Pento has worked on the floor of the N.Y.S.E. as well as serving as vice president of investments for GunnAllen Financial immediately prior to joining Delta Global.

© 2009 Copyright Michael Pento - All Rights Reserved
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