Interest Rates and Gold

Last night, in the midst of a dream, Dad appeared out of nowhere and talked to me for what seemed like hours.

He spoke about interest rates and gold. He told me about his experiences of the past and his views of the future. And all the while, he insisted I take notes to make sure I share the details with you in “Martin on Monday.”

As soon as I woke up, with Dad’s words still fresh in my memory, I turned to Elisabeth to tell her all about it. But she was gone, and for a fleeting moment, I was puzzled.

Then my mind cleared, and I remembered that she’s in Brazil with her Mom, her sister and our nephew’s family. Just yesterday morning, I drove her to Miami to catch a flight to Sao Paulo, and right now, she’s probably being smothered by our grand niece and two grand nephews, each fighting for her loving attention.

As I got up from bed, I felt a twinge of sadness as I contemplated the next two weeks in an empty house.

And as I trudged up the stairs to my home office, my mind flashed back to the days when the house was full of teenagers and young adults – our son Anthony who was finishing high school … his cousin who’s a computer programmer … an exchange student from Brazil who was learning English … an intern from Tokyo who was helping us teach Japanese at the Weiss School … not to mention their friends.

I sat at my desk and stared down at my keyboard. Then I held down the control key while tapping the N key. Instantly, Microsoft Word opened a new file, calling it “Document 4.” But alas, my recollection of Dad’s words had been swept away by the remembrances of the past few minutes.

So I got up and began rummaging through my collection of Dad’s writings and memoirs, picking out his comments on the very same topics he talked about in my dream – interest rates and gold …

THE GREATEST ECONOMIC SURPRISES OF MY LIFETIME
by J. Irving Weiss (1908-1997)

Most Americans – especially the youngsters who manage billions of dollars on Wall Street – have no concept of the power and speed of a major interest-rate upheaval.

They’ve never lived through one. So it’s hard for them to visualize it. I fully sympathize with their plight. I was also new to this business once.

I had my first experience with bonds during World War I, when I was attending grammar school in East Harlem. Our teacher asked us to sell Liberty Bonds to raise money to support the war effort.

So one Saturday I decided to walk over to the West Side with a friend of mine to try to sell some bonds. I figured I’d be lucky if I sold $50 worth, which was a lot of money in those days.

But just as we were walking through the Central Park tunnel, we saw a nicely dressed woman walking in the opposite direction. I stopped her and said: “Ma’am, would you be interested in buying a Liberty Bond?”

She smiled broadly and answered: “You’re selling Liberty Bonds!? Well, young man, I just happen to be going to the bank on Fifth Avenue to buy some Liberty Bonds. So I might as well buy them from you.”

She signed up for $500 worth! In just a few moments I had raised ten times what I expected to raise in a whole week. I was a hero in my class and was proud of every moment.

Plus, I was impressed by the demand for bonds. I never imagined that so many people would be willing and anxious to part with their hard-earned money for a piece of paper that they couldn’t use or spend in any way.

CUSTOMER’S MAN

Later, when I was 16, I went to work on Wall Street as a typist at Western Union. But I didn’t do much typing. They assigned me to the “unpack department” where my job was to sort out telegrams coming in from overseas.

Then, in 1929, I got a job as a “customer’s man” – a stock broker. I worked at the midtown branch of a boutique brokerage firm. I was so desperate for a job, I offered to work for nothing. But they said the stock exchange rules required some payment. So they gave me $10 a week.

My primary focus was on the stock market. I knew very little about bonds and interest rates. I did know the going theory – that interest rates were essentially a shadow of the inflation rate. People assumed that when we had more inflation, interest rates would go up. When we had less inflation or actual deflation, interest rates would fall.

They didn’t realize that interest rates are driven up and down by the supply and demand for bonds, and neither did I.

Boy, was I in for a big surprise! In fact, just as I began to watch rates more carefully, every single thing I thought I knew about interest rates went by the wayside.

You see, interest rates had fallen sharply during the Crash of ’29, which was to be expected. Then in the early 1930s, something absolutely astounding happened: Despite the general absence of inflation, interest rates began to surge dramatically.

The immediate reason: The demand for bonds disappeared. Worse, a lot of people who had bought too many bonds were now anxious to sell them.

The yields on low-grade corporate bonds were the first to surge as their prices plunged. It was like an aftershock from the stock market crash, but with a long time lag.

This made sense because these were bad bonds. They were issued by companies that were defaulting on their payments. A lot of the companies simply ceased to exist. So it was natural that their bonds should become worthless. The yields went to 15%, 20%, 30%. But what good was it if you lost your principal?

Then high-grade corporate bonds also got hit hard. Investors feared that any company – regardless of rating – could go belly up, and they were right! At some companies, finances deteriorated so quickly that by the time the analysts got around to downgrading them, it was too late. Amazingly, high-grade corporate bond yields surged past their pre-crash highs as their prices crashed. Someone was selling the hell out of them. But who?

You’d think that at least Treasury bonds would be protected from this selling panic. They weren’t. Investors sold them aggressively, driving their prices to new lows, just like the corporate bonds. Yields surged. Another big surprise!

WHY BONDS CRASHED

Where was all the selling coming from? What drove interest rates up when every textbook in existence said they should NOT be going up? It wasn’t until many years later that my brother Al and I began to put it all together.

To understand what was going on, we had to throw all the traditional theories about interest rates into the trash can. We had to forget about inflation, deflation, money supply, and the Federal Reserve. Instead, we looked at bonds like any other kind of investment – no different from stocks or commodities. When investors sold them, they went down in price. When investors bought them, they went up.

These investors didn’t give a hoot about textbooks. All they cared about was the fact that they were overloaded with bonds and they needed cash.

The banks had loaded up with municipal bonds, and they needed cash to meet huge demands for withdrawals.

Insurance companies had loaded up with corporate bonds, and they needed cash to pay claims.

So, tremendous amounts of bonds were dumped on the market. High-grade bonds. Low-grade bonds. Muni bonds. Treasury bonds. It didn’t matter what color or denomination. Everywhere, financial institutions and businesses were getting rid of their bonds.

They talked about their fears of inflation returning, and about the danger of “reflation,” as they called it. But later, I realized that inflation was just an excuse. The real reason they sold the bonds was because they were overloaded with bonds in the first place and needed the cash.

Mark my words: The same is bound to happen again. You’ll see people dumping bonds left and right, for no apparent reason. Some will say it’s their fear of inflation. Others will talk about the Fed. But that won’t be the main reason. The main reason will be because they’ve overinvested in bonds and want out.

Where will they go with their money? Some will flee to hard assets, like gold.

THE ORIGINAL GOLD BUGS

I’ve heard several advisors claim that they are the original gold bugs. But it’s not true. The first gold bugs of the twentieth century were friends of mine – men like Bernard Baruch, William Baxter, Thomas Bragg, and Ben Smith.

Bernard Baruch was an advisor to several presidents and is famous for having made a fortune during the crash. William Baxter was the founder of the International Economic Research Bureau. Tom Bragg and Ben Smith were floor traders specializing in gold stocks. I was writing freelance reports on inflation and gold for Baxter.

The five of us – Bill Baxter, Bernard Baruch, Tom Bragg, Ben Smith, and I – had been accumulating gold coins in a small way. In those days, very few people were buying the gold pieces. They were being used mostly for gifts and weren’t circulating. But we bought thousands of them.

Then we started on the gold shares – this time, investing in bigger amounts. The shares were grossly undervalued and consistently snubbed by most traders. In fact, back in the early ’30s, my own boss used to laugh at me for buying gold shares. Every morning, he’d rib me about it.

Gold and gold shares had a bad reputation. Earlier in the century, a bunch of shady characters used to roam the countryside peddling the shares in mining ventures which went belly up. So by the 1930s, investors gave mining companies a wide berth. But we didn’t give a darn about what other people thought or said. We figured we couldn’t go wrong if we concentrated on the biggest companies like Homestake plus a couple of big Canadian companies. We knew we were on the right track because our gold stocks started to move up nicely.

We soon had very respectable paper profits. Some of the boys were itching to get out. With the ’29 stock market crash still fresh in their memories, you couldn’t blame them for being nervous.

A SURVEY

I called a meeting at Bill Baxter’s office. Bernard Baruch was there, and so were Ben Smith and Tom Bragg. One of them alluded to the possibility of “some big selling which could hit at almost any time.” Baruch said he was hanging on. He knew something we didn’t know. But we didn’t find that out until later.

Our immediate question was: “Who’s going to do the selling and how much?” I suggested we get the facts with a survey. I got a hold of the stockholder lists of some of the big mining companies and had our staff call about 400 people at random, asking a simple series of neutral questions – “When did you buy your gold shares?” … “How much do you own?” … “What are your future plans for them?”

Boy, were we surprised when we saw the results! We never got past the second question! About half the stockholders in mining companies didn’t even know they owned the shares. The rest said they had the shares stashed away – in their attic or in a vault somewhere. None of the people had plans to sell the shares.

So I called another meeting and told the boys: “The only big source of selling would have to be from someone right here in this room.” They all breathed a sigh of relief. We held on to our shares and doubled our profits.

The banks were shipping gold out to London by the boatload. Baruch was advising FDR at the time and so he was privy to some information. He couldn’t tell us what it was, and we tried to anticipate what it might be, but none of us had any way of knowing the details. However, based on our own logic and the bits and pieces Baruch did talk about, we surmised that the President was going to restrict gold investments in some way.

We bought as much as we could, while we still could – gold coins, shares, bullion bars, you name it. When the confiscation was announced, we were ready. But we were also very surprised. We had no idea FDR was going to be that tough.

HOW GOLD MINING SHARES WENT THROUGH THE ROOF

Most investors have no idea how huge the profits were in gold shares in the 1930s. Homestake, for instance, went from a bottom of $65 per share after the crash to $130 and change in 1931. From there, it doubled again to more than $350 a share by 1933. By the time it peaked in 1936, it had climbed to $540 a share – an astronomical gain of more than $470 per share. That was a 7-fold increase.

The dividends also doubled, redoubled, and doubled again – reaching $56 per share in 1935. Think about it. The dividends earned in one year alone almost paid back the entire purchase price of the stock.

Homestake was not an isolated example. Dome, another great gold producer, did even better. You could have bought Dome for as little as $6 a share after the crash. But in the next seven years, it paid $16.60 in dividends. The dividends alone were equal to more than 2 1/2 times the cost of the stock.

Meanwhile, the price of Dome rose to $61 a share. A person who put $10,000 into Dome could have walked away with more than $100,000 – while nearly everything else remained depressed.

Tom Bragg reaped the biggest benefit. He was the largest holder of Newmont Mining. Then he left Wall Street to become a major executive in the company and stayed with gold for the big rise in subsequent years. The others made big profits also. I’m not sure how big, because these guys were very private individuals. They never boasted about how much they were making – especially when they were making a big killing.

BACK TO THE PRESENT

In many ways, we’re seeing a similar situation in interest rates and gold as Dad saw back in the 1930s.

Like then, investors (especially large institutions) are currently holding much more in bonds than they know what to do with. For the past few months, in anticipation of the Fed rate hike, they’ve been trying to unwind some of their positions, but they’ve barely made a dent in their huge holdings.

And, like then, gold and gold shares seem to be of little interest to most investors.

This alone supports the notion that bonds are bound to fall and gold is likely to rise.

HERE’S WHAT’S COMING THIS WEEK …

* Tomorrow (Tuesday), the Fed’s Open Market Committee starts its landmark meeting.

* The day after tomorrow (Wednesday) at 2pm, they announce their historic decision to raise interest rates, probably by a quarter of a percent.

* And Thursday, the long years of record low interest rates will be over.

Does this necessarily mean bond markets will plunge instantly and interest rates will skyrocket immediately?

No. By this time, even visitors from another planet should know that the Fed is going to hike interest rates on Wednesday. So after the Fed announcement, some bond investors may actually feel a temporary sense of relief, helping to cause a short-term rally in bond prices and a short decline in rates.

Two warnings: First, you can’t count on that rally. It may happen. It may not. Second, even if it does, don’t let it fool you. The big trend for bond prices is DOWN and the big trend for interest rates is UP.

HOW WILL GOLD BE AFFECTED?

Very little, I believe.

Yes, I know some gold investors are worried that higher interest rates will drive gold prices lower. And yes, that CAN happen from time to time. But interest rates don’t typically hurt gold in any lasting manner until they rise ABOVE the inflation rate. And right now, they’re not even close.

Even with the expected rate hike this week, the Fed Funds rate will still be 1.25%. Meanwhile, based on the first five months of the year, consumer price inflation is now running at the annual compound rate of 5.1%.

That’s a gap of about 385 basis points or 3.85 percentage points! As long as that kind of a gap – or even a more moderate one – persists, expect gold prices to move mostly higher as the Fed continues to fall behind the curve of rising inflation.

Indeed, as in times past, when inflation is accelerating … interest rates are rising … and bonds are falling, more often than not, gold and gold shares go up, sometimes very sharply. So make sure you’re positioned to profit from the rise.

Good luck and God bless!

Martin

Martin D. Weiss, Ph.D.
Editor, Safe Money Report
Chairman, Weiss Ratings, Inc.
martinonmonday@weissinc.com

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