Get Real

Interest rates below the rate of inflation have important investment implications
By John Sammut

Interest rates continue to hover at generational lows. Not only are conservative investors earning next to nothing on cash deposits, they are actually losing purchasing power after inflation and taxes. A key result of the ultra expansionary monetary and fiscal policies of the last 10 years is this phenomenon of negative real interest rates.

Real interest rates are simply a calculation of the rate of return that can be earned on short-term cash deposits minus the rate of inflation. As an example, if short-term interest rates are 5 percent and the inflation rate as measured by the consumer price index is 4 percent, then the real interest rate would be +1 percent (5% – 4% = +1%).

In 2004, the real interest rate went decisively negative after the Federal Reserve slashed the overnight lending rate to 1 percent following the collapse of the NASDAQ stock market and subsequent economic recession. The current real interest rate is -3.31 percent (as of Nov. 1, 2011). The last time the United States experienced negative real interest rates for such an extended period was in the mid and late 1970s.

Ramifications of negative real interest rates

  1. Negative real interest rates encourage excessive leverage (debt) and discourage private investor savings.
  2. Generally speaking, negative real interest rates are bullish for Gold prices. It takes massive expansion of money and credit to keep interest rates at artificially low levels, and massive money creation deflates the value of paper currencies to the benefit of “hard money” like precious metals. From August 1971 through January 1980, the price of gold increased from $35 per oz. to $850 per oz. Much of this parabolic rise in the 1970s can be attributed to the fact that interest rates were negative relative to the rate of inflation. It wasn’t until Federal Reserve Chairman Paul Volker dramatically raised short-term interest rates in the early 1980s that the price of gold peaked and subsequently fell.
  3. Negative real interest rates encourage investors to speculate in search of higher rates of return, which in turn causes vicious market volatility. Private investors, insurance companies, hedge funds, and banks can’t earn enough on their cash, so they are forced to take higher risks to achieve higher returns. They buy Greek and Italian bonds in search of higher yield … they buy stocks … they buy commodities. This leads to intermittent distortions in asset prices (both up and down), extraordinary financial market volatility (both up and down), and reckless decisions backed with extraordinary leverage.

In an effort to stimulate the economy, Federal Reserve Chairman Ben Bernanke has pledged to keep the Fed Funds rate at today’s level through at least mid-2013. As long as interest rates continue to be pushed below the rate of inflation, investors should expect volatility to be the norm. It’s also important to remember that volatility works in both directions – up and down, and enduring volatile markets in the short-run is necessary if one seeks to achieve higher rates of return in the long run. While cash provides reassuring stability during periods of market disruption, to invest for safety might prove to be the most dangerous strategy over the long haul.

John Sammut, a Financial Advisor with RBC Wealth Management, helps individual investors, families and corporations organize their affairs so they can make better decisions, improve results, and enjoy a peaceful state of mind. You can reach Sammut by telephone at (315)-423-1425, or visit him at www.johnmsammut.com

The opinions expressed in this report are those of the author and are not necessarily the same as those of RBC Wealth Management or its research department. RBC Wealth Management did not assist in the preparation of this report and makes no guarantees as to the accuracy or the reliability of the sources. This information should not be construed as a research report, as it is not sufficient enough to be used as the primary basis of investment decisions. Clients should work with their financial consultant to develop investment strategies tailored to their own financial circumstances.
RBC Wealth Management, a division of RBC Capital Markets, LLC, Member NYSE/FINRA/SIPC

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