Why rising interest rates are a good sign for gold

Doug Casey - Fri 13 Oct, 2006

...Interest rates are going up because inflation and default risk are going up. Lenders want to be compensated for the chance they might not be repaid...In the case of government debt, default risk is minimal since, if need be, the debtor government can always print what it owes. So rising interest rates on government debt are a clear reflection of rising inflationary pressure. And that's unquestionably a positive for gold...

 
 
Interest rates are going up because inflation and
default risk are going up. Lenders want to be
compensated for the chance they might not be repaid.
When the currency seems to be losing purchasing power,
lenders want to recover the loss by collecting more
interest, and borrowers are willing to pay it.
 
In the case of government debt, default risk is minimal
since, if need be, the debtor government can always
print what it owes. So rising interest rates on
government debt are a clear reflection of rising
inflationary pressure. And that’s unquestionably a
positive for gold.
 
A key measure of interest rates is how high they are
after subtracting inflation. By that standard, they
aren’t high now. Even though rates have risen, inflation
has also risen, so the effective real rate is still low.
But higher inflation is going to lead to higher rates.
 
In the past 12 months, the CPI has risen 4.2%, and it is
running at a 5.2% annual rate so far in 2006,
accelerating to a 5.7% annualized rate over the last 3
months. Yet, with rates on short-term Treasuries around
5%, they are still close to zero after inflation.
 
And real interest rates are almost certainly lower than
they look. To avoid reporting high inflation, the
Commerce Department has been cooking the books over the
last few years. One example is that it uses residential
rents in its CPI calculation rather than the cost of
houses, simply ignoring soaring housing prices. But from
here on, that accounting slight of hand may have the
opposite effect, as rents continue moving up and housing
prices stall.

There is more: the rental equivalent rate included a
deduction of the utilities included in rent, so as
energy prices rose, the rental equivalent rate was
calculated to be lower than the actual rents. We could
write a book on government deception, but the bottom
line is that inflation is higher than the government
indicates. Going forward, this means that one of the
most watched measures of inflation has some big rises
already baked in. When the general public is shocked by
higher inflation numbers, interest rates will reflect
that.  
 
When viewed from this perspective, the recent fallback
in metals has little importance for investors. Gold ran
ahead of itself, over-leveraged traders profited and
then panicked, and the price took a dive.
 
But there’s been no change in the big picture for gold
and silver. The world continues to be awash in a sea of
debt, with sea levels still rising from the rivers of
spending by the US and other governments. The debt-heavy
governments are egged on by organized constituencies and
prevented from cutting spending—even if they ever wanted
to—by statutory entitlement programs, entrenched
bureaucracies and, in the case of the US, the global war
between civilizations.
 
In fact, the situation is much worse — “intractable,” as
Paul Volker recently put it — than it was leading up to
gold’s bull market in the 1970s. Back then, the economy
wasn’t perched on a housing bubble perched on a pin.
Back then, the world’s central banks still sought
dollars. Back then, you didn’t have trillions of dollars
in exotic derivatives.
 
And back then foreigners, many of them now truly hostile
to the US, weren’t holding trillions of dollar assets as
reserves...


Yours,

Doug Casey
for The Daily Reckoning