Gold News

Inflation: Why Isn't Gold Working?

Inflation up, real rates through the floor. But gold...?

"YOU ARE the nation that permits Usury," wrote the deranged Osama Bin Laden in his deranged 'Letter to the American people' shortly after 9/11, says Adrian Ash, director of research at BullionVault.

Charging and paying interest on money "has been forbidden by all the religions," he said, trying to justify mass murder.

"Yet you build your economy and investments on Usury."

Fast forward 2 decades however, and with the US military pulling out of Afghanistan...a move that meets at least part of Bin Laden's demands...the USA also seems to have given up usury, too.

I mean, when was the last time you earned any interest on a Dollar bank account or loan? Or in any other major currency either?

The returns to money-lending have never been poorer.

That means borrowing has never been cheaper.

So it makes sense that a surge of new borrowing has resulted.

But quite why lenders are rushing to help is less clear.

One week this month saw the US federal government borrow $298 billion in just 3 days.

That added 1% to its massive outstanding debts between the Tuesday and Thursday alone.

Corporate America is also borrowing like never before, rushing to "lock in record-low rates" as urged by their bankers.

This wouldn't matter, perhaps, in a world of zero inflation. Not on a worldly level of trying to eat, stay warm, and save for the future at least.

But no doubt Bin Laden, that murderous multi-millionaire, also knew to beware "money illusion".

People tend to think only in cash terms, not after you account for inflation. That hides the real moves against your cost of living.
You think your investments are doing better than they are. You think you're enjoying a pay rise when your wages go up. You think those "high yield" junk bonds in your pension are at least paying you something, rather than the nothing you get from cash in the bank.
Money illusion wasn't much of a problem last decade. The UK, for instance, reported just 0.5% annual inflation across 2014-2016, and the USA averaged just 1.5% between 2013 and 2021.

In those same 96 months, annual inflation across the 19-nation Eurozone breached its central bank's upper tolerance of 2.0% just 4 times. Thanks to last year's Covid Crash in commodity prices, it then joined Japan in seeing zero and sub-zero inflation.

But now?

Inflation for Eurozone consumers hit a decade-high last month.

Within that, Germany is seeing the fastest consumer-price inflation since the aftermath of reunification.

US consumers were already suffering the highest jump in their cost-of-living for 3 decades in July...

...and any poor Brit receiving an update from their energy suppliers this summer will know to expect a big jump.

Further ahead, the pain looks certain to worsen.

Electricity costs in the UK wholesale market last week vaulted to new record highs over 5 times the last decade's average.

So put on a vest and turn down the thermostat. It's not even autumn yet.

Commodity price indices, year-on-year percentage change. Source: St.Louis Fed

Why the sudden turnaround?

Chinese manufacturers in August suffered the fastest input-price inflation in 13 years, and commodity costs for US businesses rose almost 20% from August 2020...

...the fastest 'producer price' inflation since late-1974 marked the first anniversary of the Arab Oil Embargo.

Some of this was expected, of course. The Covid Crash in early-to-mid 2020 meant that summer 2021 was sure to see strong year-on-year inflation in raw material costs. 

Crude oil prices, you will remember, actually went negative as the pandemic struck. Back up at $70 per barrel this April, it showed a record $100 per barrel year-on-year jump.

But that 'base effect' was supposed to have started wearing off by now.

Whatever inflation we got, promised the US Fed...and the European Central Bank...and the Bank of England...would only be "transitory".

Instead however, the surge of economic demand caused by the world re-opening from its Covid the massive fiscal stimulus coming from the new US government of Joe Biden...has met a supply crunch (also caused by the Covid chaos) leading to hoarding and panic buying across many natural resources.

Much of it is being driven by new green-energy targets and rules. Because whether you believe in climate change or not, and whether you change your lifestyle or not as a result, the big shift to net zero and all the other buzz-word targets will not be cost free. 

Palladium, for instance, is needed in autocatalysts which reduce harmful emissions from gasoline engines.

Already surging ahead of the Covid Crisis as tighter emissions standards spurred heavier demand, palladium soared to yet more new record highs this spring as Chinese car manufacturers bought all they could find to prepare for Beijing's next set of emissions rules...

...spooking the Communist dictatorship to crack down on "hoarding" and "speculation" in natural resources...

...but something which platinum investors might see repeated among diesel automakers (and through substitution in petrol engines too) according to the World Platinum Investment Council.

Meanwhile in Canada, "Miners race for nickel as electric car revolution looms," says the Financial Times today...

...reporting how "millions of tons" buried in northern Ontario's Esker project are enjoying a bidding war between mining companies wanting to grab hold of the battery metal while it's still in the ground, ready to unearth and sell at higher prices as governments and consumers everywhere make the switch towards electric vehicles.

Rinse and repeat across copper, steel, tin, aluminium and pretty much every other base metal gouged out of great holes in the earth using diesel-engine diggers to build the new infrastructure beneath the promise of our clean-green future.

So throw extra demand for crude oil and natural gas on top, needed to power all this mining and processing and construction... those soaring electricity prices (light winds left all the turbine towers already built providing as little as 2% of the UK's electricity needs at one point last week)...

...helping drive 6-year highs in uranium prices (nuclear might carry risks, but hey! It's 100% green until meltdown)...

...and this "transitory" inflation looks set to stay for a good while yet.

So why doesn't gold believe it?


Long-time readers of our Weekly Update emails will recognize this chart. Doubtless with a groan.

It shows the price of gold versus the real rate of interest offered to investors choosing to buy US government debt instead.

Most often, analysts today will track that "real rate" by looking at the yield offered by 10-year TIPS bonds. And that connection has become ever stronger as more and more traders see it and apply it (especially algo traders using computer bots to place their bets).

But instead of that market-based forecast...which can only run back to 2002, when the US Treasury first began selling its "inflation-protected" bonds...the chart above takes the conventional 10-year bond yield, and subtracts the actual out-turn rate of US consumer-price inflation.

This is the very real "real rate" in other words.

And as you can see, this summer's surge of inflation has sent it crashing to the most negative since 1980, the very peak of the prior decade's inflationary disaster.

Gold, however, doesn't buy it. Not yet.

Which is odd. Because major turning points in this real rate have coincided with major turns in the gold market.

Why? It's because, when money with interest payments included is losing value to inflation at an increasing pace, then rare and indestructible gold becomes increasingly attractive. And vice versa. Except today, when it's all vice and no versa so far.

To repeat: Over the 50 years since gold was cut free from the Dollar, there has scarcely been a change of trend in the gold price from significant levels which wasn't accompanied by a sharp change of direction for real bond yields.

Until today, the one stand-out exception was gold finally finding its floor, basing and then turning higher in 2000-2002.

Now we face another break of the rule...

...not a law of the universe, and much less a rule of the Almighty...

...but a guide which has applied time and again to the direction of gold prices at important levels.

What's wrong? Why is gold broken?

First, those turning points didn't occur absolutely in lockstep. A month here, a month there, and pretty soon you need to pull back to the 50-year view to see the "coincidence" that shows so clearly on our chart above.

Second, gold isn't alone in fading this surge of inflation. Commodity markets themselves may be showing signs of fatigue, with this summer's headline jumps starting to slip back just as inflation starts to reach the front pages.

Thirdly, and most telling I think, the bond market simply doesn't buy this inflation spike either.

If it did, then junk-rated US corporates couldn't borrow at the cheapest rates in history. Nor could the US government or US home buyers wanting a 30-year mortgage.

Hence the steep dive in the real interest rate to that dramatic 1980 low. Because unlike 4 decades ago, the rise of inflation isn't being offset by any rise in bond yields.

Of course, you could blame central banks directly for that. Among the major economies, they are squatting on record-low overnight rates, and they continue squatting on longer-term rates by "easing with quantity"...

...creating money at will to spend on buying bonds.

Or you could blame the "supra-secular" decline in borrowing costs (and lender returns) running across the last 800 years. First described by Sidney Homer and Richard Sylla in the mid-1990s, it was famously updated last year by Paul Schmelzing in a research paper for the Bank of England.

"Against their long-term context," says Schmelzing's analysis, "currently depressed [government] real rates are in fact converging 'back to historical trend'...[This] suggests that, irrespective of particular monetary and fiscal responses, real rates could soon enter permanently negative territory."

Trying to bet on 8-century trends, however, sounds like a quick route to going broke within your own lifetime.

More likely for now, the bond market's subdued response to the 2021 surge of inflation comes because a) lenders agree with the Fed (and gold) that this spike will fade, and b) investors in even the riskiest debt simply don't believe that they face any default risk anyway.

Again, those 2 beliefs come thanks to central bankers...

...first through a willing faith in the Fed's assurances that everything will turn out just fine again real soon...

...and second because, if debt defaults do start to rise, everyone expects central banks to flood the world with free money once again, repeating their tried-and-trusted response to the DotCom Crash, the banking crisis, the Euro debt crisis, the Brexit referendum, the Covid Catastrophe and every other 21st Century shock you can name.

Proving that faith, and also deterring big investment flows into gold right now, is the continued run of new all-time highs in the stock market.

Who needs gold when you've got the S&P500 index up 21% in a year?

Who needs gold when you've got central bankers ready to print! Print! PRINT! the moment anything bad turns up?

And who needs gold when the greatest peacetime fiscal and monetary stimulus in history means the bond market is happily ignoring a spike of inflation which government and central-bank policies risk sending higher by demanding and financing the switch from fossil fuels to green-energy tech with no pullback in energy demand or economic activity?

Maybe gold is broken. Or maybe it's right, and this inflationary spike will vanish.

Or maybe today's prices will look great value...

...and the connection with real rates will look suddenly become urgent again...

...when investors suddenly lose their faith in the high priests of the Fed, ECB and Bank of England.

Adrian Ash

Adrian Ash, BullionVault Gold News

Adrian Ash is director of research at BullionVault, the world-leading physical gold, silver and platinum market for private investors online. Formerly head of editorial at London's top publisher of private-investment advice, he was City correspondent for The Daily Reckoning from 2003 to 2008, and he has now been researching and writing daily analysis of precious metals and the wider financial markets for over 20 years. A frequent guest on BBC radio and television, Adrian is regularly quoted by the Financial Times, MarketWatch and many other respected news outlets, and his views from inside the bullion market have been sought by the Economist magazine, CNBC, Bloomberg, Germany's Handelsblatt and FAZ, plus Italy's Il Sole 24 Ore.

See the full archive of Adrian Ash articles on GoldNews.

Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

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