Price of gold to climb
with interest rates

Editor's note: The following is a guest commentary from one of WND's sponsors, Kevin DeMeritt, president of Lear Financial. If you would like to learn more about investing in precious metals, take advantage of the free information Lear Financial is making available to WND readers.

The year was 1965 and interest rates had been cut to 1.75 percent. From that point on, rates began a 15-year climb that culminated in a sky-high 15 percent in 1980.

Now, in 2003, is history in the process of repeating itself?

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Could interest rates rise for as long and as high as they did in the '70s? Without a time machine, it's impossible to tell. Rates rose in the '70s primarily because Nixon took America off the gold standard in August of 1971 and, with the printing presses suddenly free to churn out millions of new, unsupported dollars, inflation was off and running and had to be harnessed. So the Fed and the Carter administration tried fixing the problem with record high rates. That proved disastrous.

Today, we face a different set of circumstances, though with similar consequences. After years of declining mortgage rates, culminating in last June's 5.21 percent, rates suddenly shot up to 6.43 percent in the first week of August. The question is could rates keep rising from here? Could another set of unique economic factors force rates to head north for years to come?

Perhaps the stock market could provide us some clues.

"The reason the stock market is essentially stalled out is because not only did interest rates rise, but they have risen more sharply than they have at any time since May 1987, and in percentage terms they have risen more sharply than any time since 1962," said Hugh Johnson, chief investment officer at First Albany Corp.

The market, it must be obvious, does not digest rising rates very well. When interest rates skyrocket, goods and services only get more expensive, too, and it simply becomes harder for a business to carve out profits. The classic example is the 17-year period from 1965 to 1982 when rates rose and stocks budged just one measly point (from 856 DJIA to 857).

Morgan Stanley confirmed this apparent joining-of-the-hip between stocks and interest rates. Their timely study demonstrated that stocks, on the average, lost 13.8 percent within the first three months following the first interest-rate hike (after a prolonged period of rate cuts). Even a year following this first rate hike, stocks were still down another 3 percent, according to the report.

So if today's stock market is moving with glacier velocity (or worse, retreating with landslide speed), maybe it's because, with all its collective wisdom, Wall Street is foreseeing a season of rising rates, one that could conceivably result in another miring of equities.

Then there's the bond market.

Rising mortgage rates and the bond massacre

Generally speaking, bond prices fall with the anticipation of rising interest rates. So it should be of particular interest to investors that, in July, bond mutual funds had their worst drop in 16 years. The timing of the massacre couldn't have been worse: Through last June, investors had injected some $66 billion into bonds in a desperate quest for a safe alternative to stocks.

"There's been an absolute U-turn in rate expectations,'' said Rajeev Demello, who manages the equivalent of $5.8 billion in bonds at Geneva's largest private bank. "No one expects a cut anymore." Other analysts concurred. "The next move by any major central bank will be an increase," said Marc Touati, chief economist at Natexis Banques Populaires in Paris. He believes the Fed will raise rates later this year.

Why rates are rising

In the late '70s, rates rose to battle runaway inflation (which was a breathtaking 13.3 percent in 1979 and 12.5 percent in 1980). But today, with inflation hovering in the 3 percent range, why are rates jumping?

Ostensibly, it's because the American economy is "… finally poised to post sustainable real GDP growth" (a statement attributed to a recent private survey of 54 economists). But the Fed has put that "real GDP growth" at an anemic 2.4 to 2.7 percent. Other analysts are more pessimistic than that and for good reason. Unemployment recorded a nine-year high in June at 6.4 percent. What's more, the Bush administration just released new deficit projections that forecast record deficits of $455 billion this year and $475 billion next year, sharply higher than the administration's forecast earlier in the year. Why these ominous indicators point to an economy "poised for growth" is anybody's guess.

But perhaps there is another (unspoken) reason for rising rates, and maybe it has something to do with protecting the faltering dollar. The scenario looks something like this: In letting the dollar fall too quickly (by virtue of maintaining our record deficits), we set the stage for foreigners to stop investing in the United States, which makes it impossible to finance our trade deficit, and this forces us to raise interest rates to defend the dollar (before the economy is really ready for it), which, in turn, reawakens a recession.

"The cost of credit would be going up at the wrong time," said Andrew Clark, a senior research analyst at Lipper Inc. in Denver. "There would be a growing chance of the economy getting strangled."

But we may have no choice. We find ourselves in a paradox where we need foreign investment to fund our massive deficit, which is, ironically enough, created by our own trade imbalance. In essence, we need the foreigners to give us back the money we've given them. Meanwhile foreign nations, who literally hold trillions of dollars in reserve currency, can't afford to be too cavalier about allowing the dollar to collapse.

On the consumer level, Americans may be completely unprepared for rising rates. "Consumers are in a very sensitive position and aren't overly excited by the outlook," said Robert Bush, founder of ERIC Forecasting Publications. "The more interest rates rise, the more pressure it puts on the economic system."

After all, what has kept the economy afloat, in the view of many, is the record monies consumers have extracted from their homes via rock-bottom interest rates. (A Fed study estimates that homeowners raised $130 billion last year through home equity loans and lines of credit.)

"The thing that helped the economy so much was a drop in interest rates, which meant lower mortgage rates, which meant consumers have been able to tap the wealth in their homes by refinancing and taking equity out of their homes," said Rory Robertson, interest-rate strategist at Macquarie Equities (USA). "With rates having backed up so sharply, refinancing is not such a bargain anymore."

And that development could dry up spending and jolt the economy. So, in the event rates keep rising for some time to come, what's your best investment play?

The gold/rising rate relationship

One of the specific economic environments that depress stocks – and stimulate gold prices – is when interest rates head up after years of heading down.

When rates rise following a prolonged period of rate drops, the demand dynamics for gold start kicking in. Returning to that 1965 to 1980 period of rate hikes, we find that gold climbed as well. From a low of $35 in 1965 (its fixed rate at the time), gold reached a stunning $850 in 1980. This gave long-term investors in the precious metal a breathtaking profit of 2,400 percent. Silver investors, too, enjoyed a fabulous 1,500 percent gain.

For another classic example, there's the Great Crash of 1929. After the first barrage of the depression struck, stocks remained dazed and devastated while interest rates were poised to rise (following a season of decline). Under those circumstances, gold rose 75 percent – from $20 to $35 an ounce – proving to be the best (and probably only) game in town.

Now, in today's turbulent markets, when investors, stung by stock market instability, pile $66 billion into bonds only to watch that market disintegrate, investment stability and profitability have never been more absent from portfolios. With each market collapse – stocks, bonds and, perhaps next with rising rates, real estate – investors, many of whom are facing retirement, have a growing sense of urgency over where best to commit their money. But history provides a clear answer. Not only has gold historically thrived in an environment of rising rates and economic chaos, but there is every expectation that it will do so this time as well.

Special for WND readers, Lear Financial is making available free information on investing in precious metals.

With more than 20 years of industry experience, Kevin DeMeritt is president of Lear Financial, one of today's fastest growing and most successful precious metals investment firms.