Thursday, January 23, 2014

5% Interest Rates and $500 Gold! Hahaha!

The following chart shows the natural log of the quarterly average of the 10-year treasury yield. When using natural logs, constant exponential growth (or decay) is seen as a straight line.

Click to enlarge.

I have added a parabolic trend channel in red that uses the data points shown in red. I have also added a parabolic trend in blue that uses all of the data points. Note that the correlation of the blue trend line is 0.89.

The long-term trend shows that the 10-year treasury yield has been decaying (not exactly rocket science here). It's not a pure exponential decay though. Since a parabola fits the data extremely well, I think the best way to describe it is as an exponential decay trend that has been accelerating to the downside. In other words, it has been exponentially decaying at a faster and faster rate. Hello Japan?

I know past performance is not necessarily indicative of the future, but where is the actual evidence that we are in a long-term rising interest rate environment? (And not just a short-term cyclical bounce within a declining trend channel?)

You may be wondering why I singled out the 5% interest rate target in the chart (with a natural log of 1.61). Well, wonder no more! It is inspired by the financial "experts" at MSN Money. Long time readers know that I'm not all that bullish on inflation adjusted gold prices at these levels, but I believe that the following article is a study in ridiculousness. I am therefore willing to place a "gold bug" hat on my head, if only for a day. You know, it's just an effort to balance things out a bit.

January 22, 2014
MSN Money: How gold could fall below $500 an ounce

If the 10-year Treasury yield rises to 5 percent, gold will fall to $471 an ounce.

If ifs and buts were candy and nuts then we'd all have a Merry Christmas. What hubris! The price of gold is pegged to 3 digits of "scientific" precision. All you need to know is a future long-term nominal interest rate? Forehead. Desk. Whack. Whack. Whack.

To be sure, a comprehensive model of gold's price needs to include more than just interest rates.

You think? Yeah, inflation might be a good backup plan if nominal interest rates aren't enough I suppose. For example, if inflation is running at 10% and the 10-year treasury yields 5% then I think we can pretty much forget about $500 gold. Call me silly if you must. (This is not a prediction that we will see 10% inflation and 5% interest rates of course. It's just an example.)

But, according to Claude Erb, who conducted these statistical analyses, we should not be too quick to reject his simple "behavioral" model relating gold's price to the 10-Year Treasury yield.

I wish you could have seen how quick I was to reject his simpleminded "behavioral" model. It may have even been a personal best! Unfortunately, I did not have a stopwatch at the time. And even if I had a stopwatch handy, I'm 49 years old and my reflexes aren't what they once were. I'm therefore not entirely sure I could have accurately timed such a short period to 3 digits of "scientific" precision.

In the case of the gold-interest rate correlation over the last decade, Erb told me in an interview, the r-squared is a very high 0.78. ( Click here for a summary of his findings. )

Most correlations on Wall Street don’t come anywhere close to being that high. Indeed, many of the drugs that get FDA approval have lower r-squareds between their use and positive medical outcomes.

Wow! 10 years of cherry picked data offered up a very high 0.78! Color me impressed. Of course, it is based on the premise that my 28 years of cherry picked data (as seen in the chart above) with a much higher 0.89 correlation has to fail spectacularly before his prediction even kicks in. In order to get to 5% interest rates, the natural log needs to rise to 1.61 on my chart. That is well outside the channel and well removed from the blue trend line. It would indeed be a spectacular fail. Could it happen? Of course it will, someday. That someday could be a very, very long time from now though. And in the meantime, who really knows what gold will be doing?

So, in the battle between cherry picked data sets, who are you going to believe? The very highly correlated 10 year model for gold's price that does not concern itself with inflation or the extremely highly correlated 28 year model of long-term interest rates that has a certain Japanese housing bust feel to it?

Put another way, if one assumes that we are in a rising interest rate environment when we very well might not be, then all kinds of crazy predictions are possible. Why stop at 5% interest rates? What will gold's price be if interest rates hit 50%? Better not tell me $47.10 or I will laugh my motherf#$%ing @$$ off! Seriously, lol.

This is not investment advice. I'm simply offering up an alternative theory for where interest rates are headed that matches my own beliefs. It is not proof of anything. If I had a crystal ball that could accurately predict the future, then I certainly wouldn't spend time making charts or offering up gold price predictions with a whopping 3 digits of "scientific" precision. Now would I? No, sir. I'm compelled to heckle instead. It might even be a disease. Please, for the love of all that's holy, someone help me stop! :)

See Also:
The Pulp Fiction of Rising Interest Rates

Source Data:
St. Louis Fed: Custom Chart


Nathan said...

Hrm, my impression is that gold more closely tracks real interest rates, not nominal rates. As you say, some inflation context is needed.

Off topic:
Have you ever analyzed the historical trend in household size [1]? The great recession seems to have arrested the multi-decade decline in people/household and even caused a small uptick lately.

My thinking is that all the noise about "pent up demand" for housing caused by new household formation may be completely wrong. If we suppose that even a small fraction of households decide to "double up" (say 5%) that would create *millions* of excess houses. Furthermore, since newer houses are fairly large [2], doubling up doesn't necessarily mean cramped living.


Stagflationary Mark said...


Hrm, my impression is that gold more closely tracks real interest rates, not nominal rates.

Yeah, that's certainly my take on it too. I think it is silly to compare gold's price to nominal treasury yields.

You might find one of the first posts on my blog interesting.

September 5, 2007
Fed Funds Rate vs. Commodities

This is a chart of the annual Fed Funds Rate (adjusted by the CPI-U) vs. the return on various physical commodities (also adjusted by the CPI-U). At first glance, it just looks like a shotgun blast. However, there is clearly at least some order within the chaos when you add in linear regression trend lines.

Even though there is a tremendous amount of noise, these five different commodities all say almost exactly the same thing. If the real Fed Funds rate is low, it is time to own hard assets. If the real Fed Funds rate is high, it is time to sell hard assets. This lends truth to the saying that you should not fight the Fed.

I'm also of the belief that the inflation adjusted price of gold matters too. Put another way, there's a point at which gold could become too expensive relative to toilet paper. So when I say I'm not that excited about gold, I mean in relation to the price of toilet paper.

I owned gold and silver from 2004 to 2006. I thought they were a bargain both in inflation adjusted terms and in real interest rate terms. Now I'm just not so sure. Gold seems expensive in inflation adjusted terms but that price could be justified if real interest rates continue to fall. They might not though (if Japan is an indicator after their housing bust).

In any event, I bought with the intent to only sell once. I sold for a fairly hefty profit (50%). I am therefore done.

Have you ever analyzed the historical trend in household size [1]?

My thinking is that all the noise about "pent up demand" for housing caused by new household formation may be completely wrong.

Yes. Like you, I am not encouraged.

January 14, 2010
Long-term Household Formation Trends

Note that the long-term trend is no longer declining at a rapid pace. The Census Bureau's 1987 target for the year 2000 was not reached.

There's a risk that the long-term trend is forming a bottom. There's an additional risk that it won't just bottom, but that it will actually begin to reverse. The stock market's been stagnant for a decade. Unemployment is now extremely high.

The population will most likely continue to grow, but if more and more people live together in the same household ("for economic reasons" as seen above) then that's just one more headwind for the housing market.

One could argue that the household size might continue to shrink if people stopped having children for economic reasons though. Of course, in that case our population wouldn't grow. That would really hurt the ponzi scheme nature of our economy. How could we continue to borrow prosperity from our children and grandchildren if we don't produce any?

It would seem that we're very much on the same page here, when it comes to things to think about long-term.

mab said...

Which of the following doesn't belong:

1)unsustainable Gov't debt
2)Rising interest rates
3)QE = printing money
4)Bond Market Vigilantes
5)Gold is true money
6)Jim Cramer is a stock genius

Stagflationary Mark said...


January 23, 2014 at 2:14 PM?

mab said...

Obviously an obtuse question. Answer 5 doesn't belong.

Here's my thinking (and it could be faulty).

All the answers are false beliefs. Answers 1,2,3,4 & 6 are widely held false beliefs. Answer 5 on the other hand isn't a widely held false belief.

I think gold bugs derive a degree of comfort in not being part of the majority.

wv = theology!!! How fitting!

Stagflationary Mark said...


All the answers are false beliefs.

That's what I was going with so I decided that it was a trick question.

There were actually 7 things. You only numbered 6 of them.

The 7th one was the date and time stamp of your comment (as seen on my computer, PST).

I also agree with your answer to the puzzle. It's subtle but important!

I should have figured it out but I was caught up on the bond vigilantes. They are so mysterious and elusive! ;)

Stagflationary Mark said...

Hey, here's one back at you.

Which of the following doesn't belong:

1)Lenny Dykstra vs. Eddie Lampert
2)George Foreman vs Muhammad Ali
3)Kareem Abdul-Jabbar vs. Larry Bird

mab said...

Well, all I can say is that Lenny Dykstra had as much chance of making money on Wall St. as Carl THE TRUTH Williams did against Mike Tyson.

Stagflationary Mark said...



I really thought I had you there with a "great ones" theme but you homed right in on #1! ;)