How Real vs Nominal Rates Affect Your Wealth

First I want to talk a little about real vs. nominal interest rates and how it affects your wealth. Then I’m going to tie the Fed’s zero interest rates policy (ZIRP) in and discuss how this policy is extending the recession/depression.

Real Interest Rates

You may have heard the expression before, “It’s not what you make, but what you keep”. Usually this is referring to taxes which can eat up your earnings and make it more difficult to preserve or create wealth. But there is another thief after your money: inflation. When you earn a 10% rate of return, you may be satisfied that your investments are working. This 10% return is called you NOMINAL RATE. But is that a good return? Perhaps. If the rate of inflation is running at the historical average of about 3% then your REAL RETURN is 7%, the difference between your nominal return of 10% minus the 3% inflation that eats up part of your return. But what if the inflation rate is actually running at 8%? Then your real return is only 2%. That doesn’t sound so great.

CPI Adjustments

Shadow Stats is an organization that tracks inflation using the former government methods that have now been modified to account for substitution and hedonics. First, substitution refers consumer behavior that recognizes that people who prefer steak will buy steak until it becomes expensive (as it has in recent years). These people, faced with higher prices may then substitute hamburger as a less costly alternative. If that becomes too expensive, they will substitute cheap hotdogs or maybe peanut butter. This type of adjustment does not recognize a decline in the consumer’s satisfaction nor their lower quality of life. Ironically, the second type of adjustment, Hedonics, does but in the opposite way. When you can buy a new computer for $1,000 dollars but it has more computing power than last year due to a faster processor, the CPI is adjusted to reflect you are buying “more” for the same money. The net results of these adjustments have been to artificially lower the CPI since both the 1980 and 1990 changes. From Shadow Stats : “In general terms, methodological shifts in government reporting have depressed reported inflation, moving the concept of the CPI away from being a measure of the cost of living needed to maintain a constant standard of living. “

REAL, Real Interest Rates

Getting back to our example, the Fed has reported that the CPI has been zero to 2% over the last few years. This is why people on Social Security have gotten little to no increase in the past few years. In our previous example a 10% nominal return would have a real return after inflation of 8-10%. Sounds great. But as Shadow Stats reports, using the older methods, inflation has actually been about 6% using the 1990’s method and around 10% using the 1980’s method. So your 10% nominal return had only a 4% return using the 1990’s CPI method. Not so great. Worse, under the 1980’s method you real return was ZERO! 

 

Consider that most people have not experienced double digit returns in the last few years either because they hold bonds and cash in their portfolio or because they are just parking their cash in banks and earning 0-1%. This would imply that most investors and savers are actually LOSING money in real returns when the older CPI calculations are used. As of January 27^th, 2012, Morningstar shows that the S&P 500 returned just 3.45% last year, .6% over five years and 3.53% over the last 10 years. Clearly, long term investing is not working the way it did in the 80’s and 90”s.

As Dr. Ron Paul writes, the future doesn't look any better: 

The Federal Reserve's interest rate price-setting board, the FOMC, met last week. They will continue to set the federal funds rate at well below 1%, and plan to keep it low until the end of 2014. That's a year and half longer than they planned when they met just last month. Chairman Bernanke says they are keeping interest rates so low for so long because the economic outlook warrants it.
The fallacies in their reasoning would be amusing if they weren't so dangerous. The Fed wants to keep the price of money at essentially zero – in other words "free" – to boost the economy. But the boost they are attempting won't get here for another three years. That's not a recovery. And we've already tried this tactic. That's how we got into this mess in the first place: with interest rates artificially low for a very long time. Free money doesn't stimulate growth, as Japan's two lost decades clearly show. Artificially low interest rates only serve to punish saving, distort market signals, and cause further malinvestment. They also do nothing to address the only real solution to our economic woes: liquidation of the bad debt that hangs around the neck of the world's economy, preventing recovery. Artificially low interest rates merely ensure that we remain a debt-financed consumer economy guaranteed to end up with a weaker economy and higher prices.

Dr. Paul is absolutely correct on this. Why we would follow Japan as a model is beyond me as they have been in essentially a depression that has last 20 years. They’ve had ZIRP for almost that entire time and propped up “Zombie Banks” just as we are doing today. Why would we expect have different results? These are the policies of the Keynesians who believe that we can moderate the ups and downs of the economy through monetary stimulus just as President Obama tried in 2009. The results are clear: none of the real problems have been solved and the economic recovery is anemic at best. Though the unemployment rate has declined it is due almost entirely because people are dropping out of the workforce. The labor participation rate is the lowest its been since 1984 even as the number of people on food assistance hits all time highs.

So what IS the answer? Once again Dr.Paul, of the Austrian school of economics, has the answer from history:

Treasury Secretary Andrew Mellon was correct in the 1920s when he said "liquidate everything." That's what we did in the severe depression of 1920-21, and we recovered so quickly it is never even talked about. We didn't take his advice after the 1929 crash, and ended up with the Great Depression. We are committing the same mistakes, destined to live in this Great Recession for a decade or more—it has already been four years, the Fed says it will be at least three more! It's time we start rethinking what the Fed's policies are really doing to our economy, because obviously, by their own admission, they haven't helped.

To sum up, the Fed's ZIRP policies are extending the recession/depression by providing a disincentive to invest and save which limits new capital formation. As long as we "extend and pretend" and banks keep their massive non-performing assets on their balance sheet we will not have the type of new business expansion that would lead us to a strong recovery. Negative interest rates are NOT the result of free markets and actually creates all the wrong incentive needed for a recovery.

India to pay gold instead of dollars for Iranian oil.

This is truly stunning. I think there are several important things to take note of here, the least of which is India’s breaking the oil embargo in Iran. From Debka:

India is the first buyer of Iranian oil to agree to pay for its purchases in gold instead of the US dollar, debkafile's intelligence and Iranian sources report exclusively.  Those sources expect China to follow suit. India and China take about one million barrels per day, or 40 percent of Iran's total exports of 2.5 million bpd. Both are superpowers in terms of gold assets.
By trading in gold, New Delhi and Beijing enable Tehran to bypass the upcoming freeze on its central bank's assets and the oil embargo which the European Union's foreign ministers agreed to impose Monday, Jan. 23. The EU currently buys around 20 percent of Iran's oil exports.
The vast sums involved in these transactions are expected, furthermore, to boost the price of gold and depress the value of the dollar on world markets.

 

Its no surprise that people have begun holding gold as a store of value in turbulent times. After all, the global currency wars have most all countries in a race to devalue their own currencies. But who would have thought that less than six months after Federal Reserve chairman Ben Bernanke denied that gold was money, we would hear about not individuals, but countries, using gold as a medium of exchange, and here is the key, instead of DOLLARS? Since the Bretton Woods agreement, the US dollar was the world’s reserve currency. Even after the US dropped the gold standard in 1971, the US dollar remained THE international currency medium of exchange. Much talk in recent years has been made about what would become of the dollar which has been effectively devalued by around 33% in just the last ten years alone.

Today, we see the death of the dollar and the re-emergence of gold as the “currency of kings”. When nation states begin not just acquiring gold but using it for large transactions we are surely in a new era.

One last thought: as India is willing to use its central bank gold stockpiles to secure oil and preserve its economic future, our own President here in the US has determined that its in America’s national interest to block the proposed Keystone Pipeline from our neighbors in Canada to the US which would help secure our own economic future and oil independence in North America.

More on China and Gold

King World News brings us a perspective from an anonymous "London Trader" who describes "Staggering gold demand leading to shortages".  Much of this is likely driven by Eurozone troubles and Greece's coming default:

The demand for euro gold here in London is so intense it’s shocking to some of the players.  This is what has left some market participants in the US wondering why the price of gold has risen along with the dollar.  It’s because demand in the eurozone is unimaginably strong.  The euro physical gold demand is off the charts and it is creating shortages for metal, in size, here in London.

The physical gold market is actually being drained by euro gold buyers.  People are converting their euros to gold and there is only a finite amount of physical gold available.  Again, that’s why you are seeing the dollar and gold rallying together.

He also apparently has similar thoughts about my previous post on China's gold strategy:

The Chinese are long-term thinkers and they really don’t care whether they are paying $1,600 or $1,700 for gold.  What they do is get the best price they can.  When the new floor eventually becomes $1,700, they will buy everything available at that price.  When it becomes $1,800 they will buy at that price.  They are just looking to accumulate gold and they are never sellers, never.

There are two things here.  Yes, China wants a cheap gold price and they’ve been enjoying the fact the gold market was taken down.  They have recently taken another roughly 150 tons away from the Western central banks.  The Western central banks essentially donated that gold in an attempt to prop up their paper currencies.  Yet again these traitorous Western central bankers have given away more power. 

I see gold as power and once again they have given it away to the Eastern Hemisphere.  The Chinese continue to laugh.  As much as the Chinese would like to have a cheap gold price and have this manipulation keep going, they also want to bring the renminbi to the center stage.  

To them, it’s more important the Chinese currency becomes the world’s currency.  The dollar, despite the latest rally, is dying, we all know it’s dying.  So, the Chinese are moving to become the international currency of the world and the best way to do that is through gold.  It’s a very clever tactic.  Every time more gold arrives in China, the more their currency is backed, the closer they move technically to becoming the world’s reserve currency.”

The flow of gold from Western vaults to Eastern vaults is the most important symbol of the decline of the West.  As the East rises, the West falls.  “So goes the gold, so goes the power.”  Remember to be your own central bank by owning physical gold.  Many in Europe have apparently figured this out as gold demand is, “off the charts.”

Keep in mind that China has essentially nationalized their own gold mine production with the government buying 100% of gold mined domestically. More importantly, they don't sell. Once gold is bought by China, its off the market as they become long term accumulators.


And finally I leave you with this: Zerohedge reports Pricewaterhouse Coopers surveyed mining companies and found that 80% of executives expect gold to increase this year to $2,000/oz.  Central bank purchases have increased in the last few years and are expected to continue.

China takes advantage of US Fed stupidity

While the US Fed was using negative lease rates to push down the price of gold, China may have been taking advantage of the temporary low price to diversify their FX holdings. After all, the Chinese know gold is money even if Ben Bernanke thinks it isn't.

Zero Hedge reports

There is informed speculation that commercial Chinese banks may have taken advantage of the recent price dip to build stocks of coins and bars and accumulate bullion.
China's demand for physical gold bullion has rocketed past India with the country now overtaking India in the third quarter as the largest gold jewelry market according to the World Gold Council.
There is also informed speculation that some of the buying was from the People's Bank of China with one analyst telling Bloomberg that “there is always the possibility that some purchases were made by the central bank.”
As we've stated in the past, the PBOC is gradually diversifying their huge FX reserves and likely will announce upward revision of total gold reserves again in the coming months. Whether official buying is responsible for the huge surge in gold imports from Hong Kong is more difficult to ascertain The Chinese Central Bank does not release their figures on gold purchases.

 Keep in mind China has had massive trade surpluses with the US for nearly twenty years. Having seen the value of the US dollar decline by 33% since 2000, they now have had enough. At some point, it simply makes no sense for China to continue to peg the Yuan/ Reminmbi  to the US dollar. There is a point where the developed world's race to devalue currencies against each other will equalize (or at least relatively) and China's current model of keeping its own currency relatively low to boost exports will no longer work as effectively. At some point China will be faced with a choice: let its currency float against other currencies and trade freely or devise a new currency regime that will make the Yuan a competing reserve currency around the world with the US Dollar. I believe it will be the later and it will develop some type of gold backed currency in some form. This will, of course, require China to massively increase its gold holdings. CNBC's updated gold holdings by country shows China with roughly the tenth largest with 1,162 tons of gold, but that's behind France, Italy, Germany and the US which holds 8,965 tons (assuming Fort Knox is still full!).


So clearly China has a ways to go before it comes anywhere near the US but that doesn't necessarily mean they have to equal the US to have more credibility. Even a partially backed currency may seem like a more stable alternative to the Dollar or Euro, especially if we see more quantitative easing this year. China of course is playing a long game and is using the Fed's short term foolishness to their long term advantage.  

Is modern portfolio theory dead?

Origins

Modern portfolio theory is the basis for professional investment advice that you get when you see a financial advisor regardless of whether they’re from Merrill Lynch or Charles Schwab. CFA’s (Chartered Financial Analysts) & CFP’s (Certified Financial Planners) all learn the same theory. Its so engrained in the industry that to deviate from it in any substantial way is to invite a lawsuit from an unhappy client, either not getting the return they expected or experiencing more volatility than they wanted.

Modern portfolio theory is based on the idea that you can invest in different types of asset classes that do not necessarily move in tandem. The idea is that one asset class may go up while another goes down netting in a more constant growth with less volatility. For example: In 2011 the US stock market ended virtually flat performing well compared to European markets which lost 11% and the Japanese Nikkei which lost 17%.

Correlations increase

But while diversification seems to work well when markets go up, since 1998 we’ve seen more and more that when markets decline in this ever more connected global market, they move down together. In other words, just when you need these markets to have a low correlation (not moving together) they actually increase to a nearly perfect correlation to the downside. Since that year in 1998 when Russia defaulted on their bonds, and Long Term Capital Management, a hedge fund holding bonds from all over the world and levered 30 to 1, had to be bailed out by wall St when they discovered that in a bad market trading nearly stopped as nobody wanted to buy bonds in a fearful market. Again in 2001 and 2008 we saw that when the market turned down, it turned down all over the world. There was no place to hide but in short term US Treasuries.

Risk without return

Typically in investing there is a relationship between risk and return. Since risk is measured in volatility, we can expect that highly volatile investments would correspond with higher returns. Conversely, we would expect lower returns with lower volatility. What we certainly would not expect was that in 2011 the S&P 500 would have unprecedented days of moving both up & down by 300-550 points in a single day! Some intra day swings were nearly 1,000 points! And what return did investors get for all that volatility? Zero! Over the last ten years the S&P 500 has barely returned the rate of inflation. And consider, over that same period the US dollar has declined by 33% relative to other currencies! Does that sound like a good investment?

Protecting your wealth

Certainly part of what we see today is the result of globalized trade as well as globalized information. Economies are so closely tied together that when the US experiences a recession, its effects China and all of Europe. Even US companies now often receive 40% or more of their earnings abroad, effectively making them “global” investments. But it also means that the modern portfolio theory that’s worked well for the last 50 years does not work the same or as well as it used to. Investment advisors need to do more than just show you a pie chart with an asset allocation. They need to critically evaluate the potential risk of each asset class and determine if they are suitable given the current macro environment. In some cases even long term investors should be positioned for capital preservation rather than a high, short term risk of capital gain or loss. This last year especially has showed that risk and reward are not always related and that one certainly does not guarantee the other.

Capital controls coming to Italy..US next?

Ever thought capital controls were just for Banana Republic nations? Never thought you'd see it in a modern western country? Italy becomes the first with this little gem:


* An extraordinary edict making cash transactions of more than Euro 1,000 illegal (not subject to reporting – just plain illegal). Following Prodi’s own desire, the existing regime has indicated that this level will be progressively reduced to a limit as low as Euro 300. Hence cash is maybe for the first time in history no longer legal tender (over Euro 1,000, for now);
* A requirement that credit card companies report all transactions carried out by Italians, in Italy and abroad to the fiscal authorities;
* Delays and refusals by banks in allowing customers to withdraw cash balances of as little as Euro 10,000;
* Finance Police has placed cameras at the physical borders with Switzerland (see below) to register all license plates. In addition, currency-sniffing dogs have been deployed at the border.

http://maxkeiser.com/2012/01/07/if-youve-ever-read-naomi-kleins-shock-doctrine-you-already-know-that-this-will-end-in-tears/

You may recall that when Obamacare was passed there was a similar measure that had been stuck into the legislation here in the US to control cash spending by making businesses document transactions above $1,000. Its was removed in an "Oooops, too soon?" moment but was likely a foreshadowing  of what we may see in the future. People have posted on other blogs that when they attempted to close out their checking accounts to protest banks they were limited to just $4,000 per day and told the bank does not keep "large" amounts of cash at branches. Demand deposits, apparently, are not available on demand. So to some extent we already have capital controls here in the US without even knowing it.


Imagine then, what it will be like if we have a "Bank Holiday". Be prepared.

2011 US deficit was actually $4.2 TRILLION!

While we look back at 2011 with disgust at the ever increasing deficits which are now regularly around 10% of GDP, we are once again reminded just how dishonest government statistics actually are.The media, meanwhile, are either ignorant, lazy or outright complicit in misleading the American people.

Something happened between Christmas and new Years in 2011: The GAO quietly released a report detailing the deficit including the increased obligations resulting from our clueless Washington politicians. That amount, the GAO has determined is actually $4.2 TRILLION for 2011!!!

http://www.georgeholdingforcongress.com/2012/01/4-2-trillion/

But the bad news doesn't stop there. From goldsilver.com comes 34 shocking facts  that should outrage Tea Partirs and OWS alike:

#1 During fiscal year 2011, the U.S. government spent 3.7 trillion dollars but it only brought in 2.4 trillion dollars.

#2 When Ronald Reagan took office, the U.S. national debt was less than 1 trillion dollars.  Today, the U.S. national debt is over 15.2 trillion dollars.

#3 During 2011, U.S. debt surpassed 100 percent of GDP for the first time ever.

#4 According to Wikipedia, the monetary base "consists of coins, paper money (both as bank vault cash and as currency circulating in the public), and commercial banks' reserves with the central bank."  Currently the U.S. monetary base is sitting somewhere around 2.7 trillion dollars.  So if you went out and gathered all of that money up it would only make a small dent in our national debt.  But afterwards there would be no currency for anyone to use.

#5 The U.S. government spent over 454 billion dollars just on interest on the national debt during fiscal 2011.

#6 The U.S. government has total assets of 2.7 trillion dollars and has total liabilities of 17.5 trillion dollars.  The liabilities do not even count 4.7 trillion dollars of intragovernmental debt that is currently outstanding.

#7 During the Obama administration, the U.S. government has accumulated more debt than it did from the time that George Washington took office to the time that Bill Clinton took office.

#8 It is being projected that the U.S. national debt will surpass 23 trillion dollarsin 2015.

#9 According to the GAO, the U.S. government is facing 34 trillion dollars in unfunded liabilities for social insurance programs such as Social Security and Medicare.  These are obligations that we have already committed ourselves to but that we do not have any money for.

#10 Others estimate that the unfunded liabilities of the U.S. government now total over 117 trillion dollars.

#11 According to the GAO, the ratio of debt held by the public to GDP is projected to reach 287 percent of GDP by 2086.

#12 Others are much less optimistic.  A recently revised IMF policy paper entitled “An Analysis of U.S. Fiscal and Generational Imbalances: Who Will Pay and How?” projects that U.S. government debt will rise to about 400 percent of GDP by the year 2050.

#13 The United States government is responsible for more than a third of all the government debt in the entire world.

#14 If you divide up the national debt equally among all U.S. taxpayers, each taxpayer would owe approximately $134,685.

#15 Mandatory federal spending surpassed total federal revenue for the first time ever in fiscal 2011.  That was not supposed to happen until 50 years from now.

#16 Between 2007 and 2010, U.S. GDP grew by only 4.26%, but the U.S. national debt soared by 61% during that same time period.

#17 During Barack Obama's first two years in office, the U.S. government added more to the U.S. national debt than the first 100 U.S. Congresses combined.

#18 When you add up all spending by the federal government, state governments and local governments, it comes to 46.6% of GDP.

#19 Our nation is more addicted to government checks than ever before.  In 1980, government transfer payments accounted for just 11.7% of all income.  Today, government transfer payments account for 18.4% of all income.

#20 U.S. households are now actually receiving more money directly from the U.S. government than they are paying to the government in taxes.

#21 A staggering 48.5% of all Americans live in a household that receives some form of government benefits.  Back in 1983, that number was below 30 percent.

#22 Back in 1965, only one out of every 50 Americans was on Medicaid.  Today,one out of every 6 Americans is on Medicaid.

#23 In 1950, each retiree's Social Security benefit was paid for by 16U.S. workers.  According to new data from the U.S. Bureau of Labor Statistics, there are now only 1.75 full-time private sector workers for each person that is receiving Social Security benefits in the United States.

#24 The U.S. government now says that the Medicare trust fund will run out five years faster than they were projecting just last year.

#25 Right now, spending by the federal government accounts for about 24 percent of GDP.  Back in 2001, it accounted for just 18 percent.

#26 If the U.S. government was forced to use GAAP accounting principles (like all publicly-traded corporations must), the U.S. government budget deficit would be somewhere in the neighborhood of $4 trillion to $5 trillion each and every year.

#27 If you were alive when Christ was born and you spent one million dollars every single day since that point, you still would not have spent one trillion dollars by now.  But this year alone the U.S. government is going to add more than a trillion dollars to the national debt.

#28 If right this moment you went out and started spending one dollar every single second, it would take you more than 31,000 years to spend one trillion dollars.

#29 A trillion $10 bills, if they were taped end to end, would wrap around the globe more than 380 times.  That amount of money would still not be enough to pay off the U.S. national debt.

#30 If the federal government began right at this moment to repay the U.S. national debt at a rate of one dollar per second, it would take over 470,000 years to pay off the national debt.

#31 If Bill Gates gave every penny of his fortune to the U.S. government, it would only cover the U.S. budget deficit for 15 days.

#32 According to Professor Laurence J. Kotlikoff, the U.S. is facing a "fiscal gap" of over 200 trillion dollars in the future.  The following is a brief excerpt from a recent article that he did for CNN....

The government's total indebtedness -- its fiscal gap -- now stands at $211 trillion, by my arithmetic. The fiscal gap is the difference, measured in present value, between all projected future spending obligations -- including our huge defense expenditures and massive entitlement programs, as well as making interest and principal payments on the official debt -- and all projected future taxes.

#33 If you add up all forms of debt in the United States (government, business and consumer), it comes to more than 56 trillion dollars.  That is more than$683,000 per family.  Unfortunately, the average amount of savings per family in the U.S. is only about $4,735.

#34 The U.S. national debt is now more than 5000 times larger than it was when the Federal Reserve was created back in 1913.

2012 Begins A New Chapter

The sixth year of market turmoil that started with a real estate collapse in 2007 has now begun. Its hard to believe its been that long. The average economic recession in America since WWII has lasted 18 months followed by a strong recovery. Certainly that hasn't happened this time. What once seemed to be a typical downturn in the economy has revealed itself to be something quite different this time. This blog is being created to organize my own thoughts from information gathered in numerous places, as well as to communicate my findings to others who may have only a limited knowledge of markets.

Feel free to post comments as well as ask questions. I'll always do my best to respond to questions as time permits.

Happy New Year!