In my latest Market Update at paulnathan.biz, I made the case that there is evidence for the first time in years that inflation could be turning from a downward path to an upward path in the future. I'm not suggesting that the turn will be dramatic, but any turn is sufficient to buoy commodities. A turn upward in gold and silver will do wonders for gold and silver stock prices as time goes by. It is with this reasoning that I again increased my position in precious metal stocks since I wrote, "Why I'm Buying Gold Stocks", on November 7, 2014. The reasoning still holds.

From that article: "Precious metal stocks are as oversold today as they have ever been. Most are down on valuations. I think most are discounting (or already have discounted) $1000 dollar gold long ago. One of the tell-tale signs of the end of crashing commodities is the stabilizing and/or reversal of commodity stocks. Generally speaking gold stocks lead gold, and the same is true with silver stocks and most other miners...

 

"What occurs to me is this is not only a good time for individual investors to pick up well run mines for the long term, but for major mining companies to be looking to pick up junior miners with good prospects. I wouldn't be surprised to see take-overs begin soon...

"No one is predicting today that the 1140 area we just hit is the low, but it might be... Right now, precious metals stocks, commodities in general, and most resource stocks are as oversold as they have ever been in market history. Either the world is heading for a devastating deflationary recession, or these markets will stabilize in here and we'll get a playable bounce. As of today, I'm a buyer of good low cost gold and silver producers."

Gold promptly moved to 1300 by January, a couple of months later. I think we're in for another leg up straight ahead.

The CPI fell .07% last month and we are now officially in deflation as I have been warning. But I think the .07% is the low mark of the deflationary move and that we will move higher from here. It is the reversal that is important, not so much the degree.

The fall of gold recently foretold the fall in the CPI. I think the odds are now good that the worst is over for both.

The efficacy of my thesis will be confirmed or disproved most likely by the rise or fall of interest rates. Interest rates are a complicated thing to understand so I want to take a little time to explain my view of them and their importance. While gold bugs fear an increase in interest rates by the Fed, they are longer term positive in this particular environment. 

There is a natural rate of return on money and capital investment that has existed over the centuries. It ranges between 3 and 5%. The rate assumes that it is a real rate of return after inflation. If the nominal rate of return is 3% and there is 2% inflation, the real interest rate is 1% -- that's a 3% interest rate minus the takeaway of inflation of 2%. Historically, if inflation is running at 2% the nominal rate of interest would be at least 5%.

The same is true if there is deflation. If we are running at a 2% deflationary rate and interest rates are 2%, the real rate of return is 4%. That's because money will generally buy 2% more in goods and services.  So, obviously this becomes an important matter to any investor. He must ask himself "What is the real rate of return I'm receiving or paying on money?" 

It is also important to economists who want to understand the real direction of economic growth and inflation. The truth will be found in the long end of the interest rate curve. For example, the ten-year interest rate today is running around 2%. So, if you assume we have a 1% inflation rate, the real return on your investment is 1%. As you move down the curve to say 5-year notes or 2-year notes, your return moves to zero or less. Many nations have negative real interest rates today. It's because they have deflation.

In the years of the Great Depression, interest rates were 1%, the lowest in US history at that time. But the deflation rate was 8% at times. So in real terms, the lowest interest rate in history was returning 7%, one of the highest returns in history on money.

It is not the Government that is creating low interest rates, it's deflation and the search for safety. If inflation were to rise to 2%, the rate of return on 10-year treasuries should be about 5% in normal times. That's why I'm looking at the 10-year note as a tip-off that inflation may be rising. TBT is an inverse ETF on long term interest rates. If TBT is rising, long-term interest rates are rising. TBT has been falling along with gold for years, but both bounced in November. They are still low, but higher than they were a few months ago. This suggests to me that deflation is ending and inflation is beginning. 

Contrary to all those that argue that higher interest rates will cause gold to fall, I believe that rising long rates will confirm that inflation is rising and gold will compensate for the theft of inflation and rise. Just as the "smart money" was wrong that a higher dollar would cause a lower gold price, so they are wrong when it comes to higher interest rates. Gold, interest rates, and the dollar have all risen together in the last few months.

Note that as the dollar hit new high's over the last few months, gold hit it's low of 1140 in October then rose. One of the main cases of why gold was supposed to go to $1000 dollars an ounce was the rising dollar. But for 4 month's gold has been in an up-trend, even though it has backed off lately. Yet notice it is hitting higher lows on each sell-off.

I think the dollar will remain the same or go lower in the near term due to a falling increase of the GDP, which has just been cut substantially from around 5% to around 2% in the US. And if inflation rises from here which is almost inevitable, that will also put pressure on the dollar. I think the same applies to the stock market. Higher inflation and lower growth rates should cut into earnings and multiples of stocks. But gold and most all commodity stocks should move higher in spite of higher interest rates.

 

The confusion comes from the difference between the Fed's control of interest rates and the market's control. The Fed only controls the Fed funds rate. That is the rate that banks charge each other for overnight money. For the last 5 years that rate has been around zero. But the Fed funds rate has little to do with the real economy or what we pay in interest or receive in interest. That's the task of the market. A low Fed funds rate is only inflationary and stimulative when it is a subsidy that entices banks to lend aggressively. They borrow at below market rates and lend high. That is not happening. Banks are hoarding money rather than lending it as they did in the past. Lower than normal amounts of money is chasing less goods; hence, the abnormally low velocity of money.

This is demonstrated by the falling interest rates over the last few months and the falling CPI, as it has fallen to minus .04% and then to minus .07% in the last two months. The result was a fall in interest rates regardless of the fact that the Fed stopped pumping money into the economy. Only in the last few weeks have long term interest rates popped. And that I think is in anticipation of a reversal in inflation in months to come.  

Most investors and economists predicted that interest rates would rise when the Fed stopped increasing the money supply. They believed that the Fed was responsible for "artificially low interest rates.” They were wrong. Today even given the rise of the 10 year bond from around 1.5%, interest rates are only 2%; they are lower than they were in November after QE ended. And mortgage rates are at near all-time lows even though the Fed is not supplying one additional dollar to that market.

My conclusion is that a rise in interest rates will telegraph less deflation and more inflation over time. This should be reflected in the price of gold. Gold, Silver, and most commodities and their stocks should benefit.

Copper, oil, the CRB, Gold, and TBT are all bouncing off recent bottoms. Unless they reverse, the direction of gold and most commodity stocks is UP. I'm not looking for a big move in gold but I'm expecting a trending move upward throughout the year. Like I said, I've been increasing my position in good gold and silver stocks, and will continue to do so as long as the trend is higher.

For more information, see my Market Update at http://www.paulnathan.biz/.