by Alasdair Macleod, GoldMoney:
In our lifetimes, we have not seen anything like the developing economic and financial crisis. Rising interest rates are way, way behind reflecting where they should be.
Interest rates have yet to discount the continuing loss of purchasing power in all major currencies. The theory of time preference suggests that central bank interest rates should be multiples higher, to compensate for the current loss of currency purchasing power, enhanced counterparty risk, and a rapidly deteriorating economic and monetary outlook.
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There is no doubt that the majority of investors are not even aware of the true scale of danger that interest rates pose to their financial assets. Some wealthier, more prescient investors are only in the early stages of beginning to worry. But if you liquidate your portfolio, you end up with depreciating cash paying insufficient interest. What can you do to escape the fiat currency trap?
This article argues that having everything in fiat currencies is the problem. The solution is a flight into real money, that is only physical gold — the rest is rapidly depreciating fiat credit. Owning real money is the only way to escape the calamity that is engulfing our current economic, financial, and fiat currency world.
Avoiding risk to one’s capital
From conversations with family and friends, one detects an uneasy awareness of increasing risk to investments. There are two broad camps. The first and the majority are only aware that interest rates are rising, and their stocks and shares are falling in value but fail to make the connection fully. The second camp is beginning to worry that there’s something very seriously wrong.
Investors in the first camp have usually delegated investment decisions to financial advisers, and through them to portfolio managers of mutual funds. They have taken comfort in leaving investment decisions to the experts, and besides the odd hiccup, have been rewarded with reasonably consistent gains, certainly since the early noughties, and in many cases before. They trust their advisers. Meanwhile, their advisers are rewarded by the volume of assets under their management or by fees.
Both methods of reward ensure that the vast majority of professional managers and advisers are perennially bullish, further justified by that long-term bullish trend.
This leaves the majority of investors being led into believing that falling financial asset values represent a buying opportunity. After all, their experience for some time has been that it is wrong to sell when markets fall, because they have always recovered and gone higher. And this is the approach promoted by the majority of professional financial service providers because they are always bullish.
The other far smaller camp is comprised of those who think more for themselves. They are beginning to make a connection between rising interest rates and falling markets but are badly underestimating the extent to which interest rates should rise.
This camp knows that the sensible thing to do when interest rates rise materially is to sell financial assets. They know that investing in physical property, tangible assets, is equally dangerous because at the margin prices are set by mortgage interest rates which are now rising. But they equally find that just sitting on cash is an unattractive proposition, with consumer prices rising and chipping away at its purchasing power. So, what is to be done?
Just leaving it in the bank pays derisory interest. And besides, the proceeds of liquidated portfolios usually exceed government deposit guarantees, which means taking onboard the risk that banks might fail. There are things that can be done, such as investing in short term government bonds as a temporary solution, and perhaps buying some inflation-linked government bonds (TIPS). Other than investing in TIPS, the loss of purchasing power problem remains unresolved. And increasingly, these savvy investors are now waking up to currency risk, particularly if they are British, European, or Japanese. The cost of investment safety in nearly all currencies is rising relative to the dollar.
I tell these people that the problem is simple: they have all their eggs in a fiat currency basket. The black and white solution is to get out of fiat by selling financial assets and the fiat cash raised by hoarding real money, that is physical gold in bar and coin form. The argument usually falls on deaf ears, because people only understood the monetary role of gold before the Second World War. That generation has mainly passed away. Why gold is so important has to be explained all over again to a sceptical audience.
We then meet two further barriers raised by the sceptics: gold yields nothing, when investors have been used to receiving dividends and interest. And if gold is the answer, why is it performing so badly? These questions will be addressed.
But all is at stake. Driven by interest rates rising even more and as the bear market continues, investors relying on investment managers and financial advisers will lose nearly everything.
A seventies redux
Global economic conditions today are strikingly similar to UK financial markets in late-1972 and early 1973. Previously, in the autumn of 1970 the new Chancellor of the Exchequer, Tony Barber, had come under pressure from Prime Minister Edward Heath to stimulate Britain’s economy by running an inflationary budget deficit, combined with a deliberate suppression of interest rates from 7% to 5%. Heath was a Keynesian disciple. And in those days, the Bank of England was under the direct command of Heath’s government, its so-called independence only arriving far later.
The rate of price inflation rose slightly from 6.4% in 1970 to 7.1% in 1972. The inflationary consequences of the Barber boom and the reduction of interest rates to negative real values were beginning to bite. Meanwhile, investors had enjoyed an equity bull market. Consumer price inflation then began to rise in earnest. In 1973 it was 9.1%, in 1974 16%, and in 1975 a staggering 24.2%. All this is being replicated today — we are probably where Britain was in late-1972.
While the dramatic increases in the rate of price inflation were unforeseen in 1972, being far greater today the stimulus of budget deficits and suppressed interest rates is having a more rapid effect. The gap between official interest rates and the rate of price inflation is magnitudes greater, with the Bank of England’s base rate at 1.75% and consumer prices rising at 8.6%. Even the Bank expects significantly higher CPI rates, with independent estimates forecasting yet higher CPI rates in the new year. Similar stories are to be found worldwide. The comparison with the UK in the early 1970s suggests the inflationary and interest rate consequences today are likely to be even more dramatic for financial assets and for the currencies themselves.
In May 1972, the FT30 Index (the headline measure of share prices at that time) peaked at 534, and a year later had already declined significantly, as interest rates began to rise. In late-October 1973 the bubble in commercial office property began to implode. The proximate cause was the rise in short-term interest rates from 7.5% in June 1973 to 11.5% in July, and 13% in November. Consequently, banks which were lending to commercial property speculators collapsed in the notorious secondary banking crisis. And the FT30 Index continued to decline until early-January 1975, losing 74% from the May-1972 peak. Similarly, this is beginning to play out today.
What’s happening now differs in some key respects from the UK in the early seventies. From negative and zero starting points, interest rates have much more substantial increases in prospect. The gap between bond yields and consumer price inflation is now far larger in the US, EU, and UK than anything seen in the early seventies. It suggests the consequences of rising interest rates today are likely to be far more financially violent than that experienced in the UK between May 1972 and January 1975. We will be lucky if equity markets lose only 74% this time.
But overall, the lesson is clear: sharply rising interest rates are lethal for investors.
We now turn to gold. Bretton Woods having been suspended in August 1971, the price of gold in sterling rose from £17.885 per ounce at that time when sterling interest rates were 6%, to over £40 when interest rates were raised to 13% in November 1974. The lesson learned is that the best hedge out of an inflation-driven collapse of conventional investments is gold. The common belief that rising interest rates are bad for gold because it has no yield is disproved.
