Positive Real Interest Rates

[Gosso]

Gold appears to have a reasonable correlation to real interest rates (there are several articles on this topic if you Google "real interest rates gold").  



Would anyone else consider lowering their weighting of gold if/when we begin to see real interest rates above ~2%?  I think it might be reasonable to drop gold down to a 10-15% weighting if this happens, maybe even lower.

I plugged the following scenario into Simba:
- between Jan 1, 1972 and Dec 31, 1981, a standard 4x25% PP
- between Jan 1, 1982 and Dec 31, 2002, either 30% Stocks / 30% LLT / 30% STT / 10% Gold or 34% Stocks / 33% LLT / 33% STT.
- between Jan 1, 2003 and Dec 31, 2002, a standard 4x25% PP

Here are the results (the blue line is switched to either the PP or 30/30/30/10, depending on the real interest rate, while the pink line is switched between the PP and 34/33/33):

Code: Select all

	(PP or 30/30/30/10)	(PP or 34/33/33)	(PP)	(30/30/30/10)	(34/33/33)
1972	18.60%	18.60%	18.60%	12.59%	8.59%
1973	14.36%	14.36%	14.36%	2.99%	-4.61%
1974	14.41%	14.41%	14.41%	2.88%	-4.82%
1975	6.84%	6.84%	6.84%	13.73%	18.34%
1976	11.77%	11.77%	11.77%	15.02%	17.20%
1977	5.06%	5.06%	5.06%	1.64%	-0.64%
1978	11.88%	11.88%	11.88%	6.97%	3.69%
1979	39.27%	39.27%	39.27%	21.99%	10.49%
1980	14.18%	14.18%	14.18%	14.07%	14.02%
1981	-4.13%	-4.13%	-4.13%	1.62%	5.44%
1982	25.39%	26.59%	23.57%	25.39%	26.59%
1983	7.49%	10.19%	3.47%	7.49%	10.19%
1984	7.65%	10.66%	3.12%	7.65%	10.66%
1985	23.18%	25.18%	20.19%	23.18%	25.18%
1986	17.58%	17.22%	18.12%	17.58%	17.22%
1987	3.39%	1.35%	6.44%	3.39%	1.35%
1988	8.21%	10.86%	4.24%	8.21%	10.86%
1989	16.18%	18.34%	12.94%	16.18%	18.34%
1990	2.28%	2.73%	1.59%	2.28%	2.73%
1991	17.64%	20.78%	12.96%	17.64%	20.78%
1992	6.43%	7.82%	4.34%	6.43%	7.82%
1993	11.80%	11.20%	12.70%	11.80%	11.20%
1994	-2.59%	-2.59%	-2.58%	-2.59%	-2.59%
1995	23.46%	26.01%	19.65%	23.46%	26.01%
1996	6.73%	8.05%	4.78%	6.73%	8.05%
1997	13.21%	17.11%	7.39%	13.21%	17.11%
1998	12.98%	14.57%	10.61%	12.98%	14.57%
1999	5.14%	5.68%	4.36%	5.14%	5.68%
2000	4.81%	5.98%	3.04%	4.81%	5.98%
2001	0.39%	0.37%	0.39%	0.39%	0.37%
2002	3.61%	1.22%	7.17%	3.61%	1.22%
2003	13.88%	13.88%	13.88%	12.84%	12.16%
2004	6.29%	6.29%	6.29%	6.65%	6.90%
2005	8.03%	8.03%	8.03%	6.08%	4.79%
2006	10.74%	10.74%	10.74%	8.50%	7.02%
2007	13.30%	13.30%	13.30%	9.84%	7.54%
2008	-0.72%	-0.72%	-0.72%	-1.86%	-2.65%
2009	10.52%	10.52%	10.52%	7.83%	6.05%
2010	14.48%	14.48%	14.48%	11.53%	9.56%
2011	10.52%	10.52%	10.52%	10.71%	10.82%

STDEV	8.21%	8.62%	7.99%	6.95%	8.05%
AVG	10.86%	11.47%	9.95%	9.51%	9.23%

The end result of dropping gold down to 10% when real interest rates are above 2% is an extra 0.90% annual gain with slightly higher volatility.  Not too shabby.

Also, during +2% real interest rate periods, one could reduce the PP to 50% of their portfolio and then put the rest in a 34% stock, 33% LLT, and 33% STT.

Of course this all depends on gold maintaining its correlation with real interest rates.  And to avoid jumping back and forth, I might use a 2 year average of the real interest rate to decide when to switch.

Edit: Fix typos.

[craigr]

Real interest rates can change suddenly in an economy. The opportunity to react could be lost in many cases.

Yes, I'm always the stick in the mud aren't I?

[Gosso]

Real interest rates can change suddenly in an economy. The opportunity to react could be lost in many cases.

Yes, I'm always the stick in the mud aren't I?

I agree it would be a little tricky to know when to switch due to the large swings between negative and positive real interest rates, but we could use a 2 or 3 year trailing average to help smooth things out.  I may do some more data crunching later to figure this out.

Just for fun I switched to 100% gold when real interest rates went below 2% and then 100% STT above 2% (the same time period in the above analysis), and I got an average annual return of 16.0%!... although the standard deviation was 26.3%    I can probably handle that 

[craigr]

Real interest rates can change suddenly in an economy. The opportunity to react could be lost in many cases.

Yes, I'm always the stick in the mud aren't I?

I agree it would be a little tricky to know when to switch due to the large swings between negative and positive real interest rates, but we could use a 2 or 3 year trailing average to help smooth things out.  I may do some more data crunching later to figure this out.

The rub of course is do you have the guts to go changing your asset allocation when the rates show you time to move? Kind of the dilemma moving average timers have to face. You need to both sell and buy. Each time you get a brand new chance to second guess yourself! 

Just for fun I switched to 100% gold when real interest rates went below 2% and then 100% STT above 2% (the same time period in the above analysis), and I got an average annual return of 16.0%!... although the standard deviation was 26.3%    I can probably handle that 

I see a new book coming out of this!

[Lone Wolf]

Very cool analysis!  Sounds like a solid basis for a VP strategy.  Just convert that VP into a PP when real interest rates drop below 2% and run it as stocks/LTT/STT when they climb again.

That'd be a purely VP play, of course.  The "money you can't afford to lose" of course has to have some gold in it!

[Gosso]

Very cool analysis!  Sounds like a solid basis for a VP strategy.  Just convert that VP into a PP when real interest rates drop below 2% and run it as stocks/LTT/STT when they climb again.

That'd be a purely VP play, of course.  The "money you can't afford to lose" of course has to have some gold in it!

And when you think about it it makes perfect sense.  When real interest rates are above ~2.5%, short-term treasuries are very attractive since the government is fairly compensating us for holding their financial instruments.  Gold is not attractive since it pays no interest and can therefore not compete during a +2.5% real interest rate environment.  When real rates are below ~2.5% then investors will be looking elsewhere for a +2.5% real return, and gold is typically a good choice. 

Of course there will likely be lots of doomer porn telling us not to buy US treasuries when they are above +2.5% real rates, but that stuff doesn't affect me like it used to.

In some ways buying gold is similar to a currency carry trade, where one borrows (shorts) the low interest currency and then buys the high interest currency.  So if the US begins to pay a high real interest rate then the USD/Gold carry trade falls apart, resulting in gold falling (significantly?) and USD increasing in value.

I will be keeping an eye on real interest rates.  The inflation figures for June will be released on July 17th.

Having said all that, I still will always have at least 10% of my portfolio in gold, since it is still a good diversifier and a hedge against unexpected events (ie black swans).

[cowboyhat]

If this - real rates explanation is accurate, you could probably collect most of the profits in gold speculation from the current bubble and not worry too much about the tedium of following real interest rates by just watching politics and applying a little common sense character judgement. We aren't going to have an extended period of + real rates until someone comes to power with giant cajones and enough political chips to keep the easy money crowd (basically 95% of Americans) at bay. If that person ever shows up stocks and bonds are probably going to eat it too. Cash will be the only place to hide.

[Gosso]

If this - real rates explanation is accurate, you could probably collect most of the profits in gold speculation from the current bubble and not worry too much about the tedium of following real interest rates by just watching politics and applying a little common sense character judgement. We aren't going to have an extended period of + real rates until someone comes to power with giant cajones and enough political chips to keep the easy money crowd (basically 95% of Americans) at bay. If that person ever shows up stocks and bonds are probably going to eat it too. Cash will be the only place to hide.

I agree that the likelihood of +3% real interest rates is slim, although it could occur from a sustained deflation of +3%.

One thing that concerns me with all this speculation is the possibility of no long term bull market in either stocks or gold -- we simply enter a period of choppiness or short term bull markets.  However, in this scenario the standard PP will likely perform well.

[Wonk]

Real interest rates are the place to look when evaluating gold prices.  That, and the secular trend.  The powers-that-be have choices to make: either devalue their currencies or allow markets to liquidate.  The former seems like a near certainty to me, so I choose gold. 

Seems like this correction has scared the weak hands out of the precious metals market, which is a fantastic opportunity for the rest of us who are planning to stay in for the next several years.  When real rates go positive again in earnest, look out below!

By the way, this is just my opinion, but it seems to me the 2% figure coincides nicely with the global production of gold long term: about 2%.

[Gosso]

If anyone is really interested in this negative correlation then I'd recommend reading "Gibson's Paradox and the Gold Standard".  It discusses how the Gibson's Paradox disappeared once the gold standard was eliminated, and how real interest rates are tied to the price of gold.

[Greg]

I'm really liking this idea. I'm right now at a standard PP but if 10 year treasuries start going up I may turn this into the VP play. Having a 1-2 year filter on it would probably help then for determining the ball-park figure of ~2% real interest rate or so to make the switch. Like with the balancing bands you'd have to create perhaps a rigid set of rules for rebalancing. Perhaps you switch if it gets to ~2% but if it goes below ~1.5% you jump back into gold and don't sell gold again until it gets back over ~2%.

[doodle]

How are you determining real interest rates? Are you basing it off of gov CPI numbers?

Also, are positive real interest rates sustainable in an environment where debt to GDP is over 100%? It seems to me that like Japan, interest rates are going to have to stay long for a looooonngg time if government ever hopes to reduce debt to GDP ratio. Financial repression seems like a long term outcome of governments balance sheet situation.

[Greg]

Gosso,

I really like your original post here, and how you showed both 30/30/30/10 of Stocks/LT Bonds/ST Bonds/Gold and 34/33/33/0. You said later in the thread though that you'd have at least 10% in gold and that the 34/33/33/0 is just for show. That's probably a good idea in that regard since as you said, you never know when black swans come about and you'll be happy you have gold (i.e. Mad Max/Leatherchaps scenario)

Craigr,

By any chance is a real interest rate chart and gold such as the one in this thread shown in the book under the Gold heading or the VP heading? I haven't purchased the book yet since I'm waiting for the hard copy hah.

[Gosso]

Gosso,

I really like your original post here, and how you showed both 30/30/30/10 of Stocks/LT Bonds/ST Bonds/Gold and 34/33/33/0. You said later in the thread though that you'd have at least 10% in gold and that the 34/33/33/0 is just for show. That's probably a good idea in that regard since as you said, you never know when black swans come about and you'll be happy you have gold (i.e. Mad Max/Leatherchaps scenario)

I have become a little more skeptical of this theory, since I'm not sure if the relationship will continue into the future.  Imagine the US turns Japanese and has low real rates for the foreseeable future, then China continues to power along and starts battling inflation with high real interest rates.  Would the Chinese start dumping gold for the juicy risk-free real return, causing gold to fall (collapse?)?  I'm not sure how the currency fluctuations would impact the price of gold in USD, but I'd guess it wouldn't be enough.

Maybe a global real interest rate would be more appropriate?

Having said that, I do have some money in the VP that invests based on real interest rates (and dow-gold ratio, volatility, bubble activity, Fed actions).  I'll likely leave the PP alone and do all the tinkering in the VP.

[Gosso]

Having said that, I do have some money in the VP that invests based on real interest rates (and dow-gold ratio, volatility, bubble activity, Fed actions).

Gosso, could you please elaborate on each of these?

Well, this is the "go-big-or-go-home" part of the VP.  Basically I'm assuming that gold is in a strong bull market, but I need to identify the various conditions that would cause the bull to die.  I think the following will do the job:

1.  Real Rates.  I explained this earlier in the thread, where it can act as a carry trade.

2.  Gold-Dow Ratio.  Once this ratio falls below ~2, then it may be time to lighten up on gold.  Although it could go a lot lower.

3.  Volatility.  Almost every bull market ends with extremely high volatility.  Daily price movement of gold during Jan 1980:
6.68%
13.06%
-5.70%
6.38%
-2.88%
-2.68%
1.50%
0.29%
6.19%
5.29%
12.17%
-4.80%
13.35%
2.12%
-9.49%
-14.81%
9.54%
-2.88%
-9.04%
7.79%
3.76%
-5.05%

(Does anyone else find it strange that a lot of bull markets end at the start of a new decade, ie Nikkei (1990), Nasdaq (2000), Gold (1980), Great Depression (1930))

4.  Bubble Activity.  Basically looking for parabolic moves.

5.  Fed Activity.  Have they signaled increasing interest rates.  Have they become serious about taming inflation (if we ever see it again).  Also, I'll look at global M2 growth, since I think gold is somewhat tied to it, except gold will massively over and under shoot it.  Below I have indexed global M2 and US M2 to the price of gold in 1968.  I make a lot of assumptions with the global M2, such as China and Euro M2 growth being the same as US from 1968-1980, and I couldn't find decent UK M2 data.  So this is not overly accurate, but it matches my preconceived notions, so I'll go with it



If I ever get the urge to sell, then I'll come back to these five variables and evaluate what they are telling me.  If enough of them are negative then I'll likely sell and move to cash and wait for the stock bull to emerge.