Analytically, there are three components to an interest rate. The first is the risk that the money will not be paid back. This is a very big factor when dealing with corporate bonds, especially junk bonds. For the U.S. government’s obligations, as the owner of a nice shiny printing press that can always be turned on to pay back any obligation denominated in dollars, that part is assumed to be zero.
The second part is expected inflation. After all, if you decide that you want to consume something later, rather than today, and thus decide to save and invest your money, you want to be sure the dollar you put away today buys at least as much in, say, ten years that it does today. If you expect that it will buy less bread, gasoline and clothing in ten years, then you would demand a higher interest rate to offset the diminution in purchasing power.
Finally, most people would rather enjoy themselves today rather than put off that enjoyment until some time in the future. As a result they demand a real interest rate, over and above the rate of inflation, to reward them for their delayed gratification, even if there is no risk that they will not be paid back.
Since 2003, the government has been selling bonds where the amount of the principal that gets paid back when the bond matures rises with the rate of inflation over the life of the bond, called TIPS. Aside from the fact that it is a much smaller and illiquid market than that of regular T-notes, TIPS make a great vehicle for tracking the real rate of interest that investors want in return for consuming later, rather than today.
Well, if repayment risk is assumed to be zero, and we know what the real rate is, then the difference between a regular T-note and the TIPS of the same maturity is what the market expects inflation to be over the life of the bonds. The yield on regular 10-year T-notes is shown in blue in the graph below, while the rate on 10-year TIPS is in pink, and the difference is shown in yellow.
Since TIPS were introduced, the average difference has been 2.17%. As of last week, the difference was 2.12%. In other words, the market does not expect inflation to be more of a problem over the next ten years than it has feared about inflation since 2003.
Aside from the price of oil and some other commodities, the last six or seven years have not been a particularly high inflation time (well, they have been for Health Care and Education, too, but overall inflation has been pretty well contained). Aside from the dislocations last year, which were arguably as much about the relative lack of liquidity in the TIPS market, this market-based measure of expected inflation has been remarkably stable — much more stable than the yield on either regular T-notes or of TIPS.
While it is true that the implied inflation has been climbing since it almost hit zero last year, it is not at levels that suggest inflation is going to skyrocket.
This means that the Fed should be far more concerned about getting the economy moving again. Any move to tighten up monetary policy by raising interest rates would be a serious mistake. Historically, the Fed has not started to increase the Fed Funds rate until well after the unemployment rate has peaked — more than a year, in the case of the last two cycles. Those unemployment peaks looked more like the Catskills versus the Andes sized peaks we have today, and unemployment is still rising.
Keep in mind that the unemployment rate will most likely continue to rise, even after the economy starts to, on balance, create new jobs. That is because there are probably a huge number of people who have become discouraged about their chances of getting a job and have stopped looking. Others have gone back to school or done other things that take them out of the formal labor force. As soon as it looks like companies are hiring again, they are likely to flood back into the labor market.
How, then, does one explain the recent move in the price of gold to over $1,100 an ounce? Historically, gold has been seen as the ultimate inflation hedge. Its rise over the past year to record nominal levels (it would have to roughly double to match its inflation-adjusted high’s set back in 1979) would seem to indicate that the market is afraid of inflation. How do we square this with data from the TIPS market, which indicates the market sees no real problem with inflation?
One reason might be the rise of India, although that would not explain the day-to-day moves. Historically and culturally, Indian’s have a far higher propensity to store their wealth in the form of gold, specifically in jewelry, not bullion, than the rest of the world does. That said, I don’t think that the 200 metric tons recently bought by the Reserve Bank of India is about to be turned into necklaces and earrings anytime soon.
Still, as millions and millions of Indians become more middle class, the demand for gold has gone up. To a lesser extent, this holds true for China as well. Even more Chinese are becoming wealthy or at least middle class than are Indians, although the cultural propensity to hold gold is not quite as strong.
Part of it might just be that we have not found that many new gold mines recently, and the ore grades in places like South Africa have been going down. That, combined with rising demand, is a classic recipe for rising prices — even if people are not expecting a return of 1970’s-style inflation.
The second graph, from Goldnews.billionvault.com, shows that total world gold production has been falling over the last five years following steady growth in the over 20 years preceding that. That would mean good things for the gold miners who have large reserves of gold in the ground, especially if they are able to increase production when the rest of the world is seeing production decline. Freeport McMoRan (FCX) and Barrick Gold Corp. (ABX) are good examples of such companies.
Read the full analyst report on “FCX”
Read the full analyst report on “ABX”
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