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Dr. Jeffrey Lewis

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QE Focus Ignores 800 Lb Gorilla

By Dr. Jeffrey Lewis      Printer Friendly Version Bookmark and Share
Nov 5 2010 10:38AM

While investors sit idly by, waiting for any confirmation in direction of Fed policy-making, a much larger issue is being critically overlooked.  That issue, of course, is negative real interest rates.

Negative Real Interest Rates

Negative real interest rates occur when the rate of inflation is greater than the cost to borrow.  Therefore, if inflation was 5% and the cost to borrow is only 4%, one could effectively earn 1% per year in purchasing power, pending they could purchase an asset that tightly tracked the rate of inflation. 

Insert precious metals.  Since precious metals have tracked inflation since nearly forever, they've become a staple in the negative real interest trade.  Investors can afford to leverage up, buy hordes of precious metals, and simply sit in wait while their metals appreciate at 5% per year (example inflation rate) and their debt grows by just 4% (also an example).  While this 1% real return won't make anyone a purchasing power billionaire, leveraging will.

The average American who wants to buy a new home might find acquiring capital a labor intensive process, but on Wall Street, easy credit is also available.  Simply opening a new trading account entitles most to margin, and traders have little problem accessing leveraged lines for carry trades like gold.  Therefore, going forward, we should expect little in the way of big investors seeking nominal and adjusted profits in a negative interest rate trade.  Just like the carry trade ultimately broke several currency pairs, it'll break the price of metals – and for the better!

When opportunity is spotted in arbitraging rates, volume and interest explode.  Where only a few people would play gold without leverage, a number of speculative investors will be willing to leverage to infinity to buy as much gold as they can. 

However, while the supply of paper and credit to buy all the gold imaginable is there, the gold isn't.  The supplies are still horribly low, and any increased interest will go directly to the bottom line.  What happens when you add more customers to an already sold out store?  Extreme prices.

Quantitative Easing is Icing on the Cake

At this point, any quantitative easing from the Federal Reserve is merely icing on the cake and nothing more.  Negative real rates, with or without any moves by the Fed, will persist until rates, not the supply of money, rise.  Inflation, of course, would rise with quantitative easing, but with so much money on reserve, and so little being lent, there's still plenty of time for higher inflation and lower interest rates.

The market has taken future quantitative easing to mean higher gold and silver prices, and that without quantitative easing, prices will simply stagnate.   This, of course, couldn't be further from the truth.  We're sitting atop record low money multiples, microscopic interest rates, higher inflation rates and plenty of incentives for leveraged investors to start picking up physical assets. 

It does not matter what number Ben Bernanke ultimately decides will be required to bring the economy back to life.  The only numbers that matter are his already $1 trillion-plus quantitative easing and negative interest rates. 

Dr. Jeff Lewis



Dr. Jeffrey Lewis, in addition to running a busy medical practice, is the editor of and