Pinetree Capital Resource Analyst Craig Stanley sheds some light for The Gold Report on how real interest rates are driving gold's rise. Although the 10-year real rate is positive now, he says if it goes negative, and stays negative, "Look out. The gold price could really spike." In this exclusive Gold Report interview, he discusses some of the junior exploration and development companies in Pinetree's portfolio.

The Gold Report: Craig, in June you wrote that real interest rates are the primary factor driving the rise in gold prices. Can you elaborate?

Craig Stanley: It's important to know the fundamental drivers of the price of any financial asset or commodity in order to determine the long-term trend. For commodities like copper, you have to focus on factors such as mine supply and scrap on the supply side, and GDP forecasts, restocking and index demand on the demand side. But gold is different. It's stored, not consumed in the traditional sense. Hence, basically all the gold ever mined can come back to the market

Real interest rates are the only metric that is correlated with the gold price. If you can hold U.S. dollars via Treasury bills, notes or bonds and they are paying a positive real interest rate that is not being inflated away, then why hold gold that doesn't pay anything?

However, it is not a linear relationship. Instead, gold prices tend to significantly increase only if real rates become negative. The current bull market in gold that started in 2001 corresponds to U.S. three-month Treasury bill real rates falling below 0%.

That's why I like to state that gold is money—money that offers no yield (a negative yield after taking into account storage and insurance) and which is continually valued against fiat currencies that offer a yield.

During times of low to negative real interest rates, gold reclaims its traditional role as money, with investment demand the prime driver of the gold price.

During the summer, the gold price in U.S. dollars stagnated as the three-month nominal rate was flat. Then starting in September, the three-month yield started to fall as inflation expectations (as measured by The University of Michigan one-year inflation expectations) rose, meaning real rates went negative and gold price went higher.

TGR: Using the real interest rates measurement, is that a price where gold overcompensates for negative real interest rates? What is that price?

CS: Real rates are a measure to identify the long-term trend of the Gold price, not a short-term trading tool. And there is not a specific gold price that compensates for a specific real rate. Look at the trend and focus on when real rates go negative.

Given the U.S. dollar's role as the world's reserve currency, I look at U.S. interest rates. The gold price starts to rise when three-month real rates go negative (when rates are positive, you're getting paid to hold dollars whereas gold doesn't pay anything). However the gold price really takes off when 10-year real rates go negative. That's what happened in 1979 and very briefly at the end of 2007. The 10-year real rate is positive right now, around 1.6%. As the three-month rate is negative, it's positive for the gold price but if the 10-year real rate goes negative and stays in negative territory, look out. The gold price could really spike.

TGR: Given the tremendous increase in metals prices, why can't most mining companies greatly increase profits?

CS: Some producers have been able to increase free cash flow. But in general, for the gold miners, up until the past year, prices for the inputs used in building and maintaining mines rose faster than the gold price. On average, these inputs, such as labor, steel, diesel and increased over 15% annually. However since peaking in 2008 these costs have come down and should flow through to the bottom line once higher cost inventories are worked through.

In addition, foreign exchange has had a big impact. In general, cash costs have increased for mines operating outside the U.S. as the greenback has declined.

Another factor that is rarely discussed is decrease in average grade—in order to produce the same amount of ounces each year, companies have been moving an ever-increasing amount of rock.

Of course, even if earnings and cash flow increase, they won't necessarily on a per-share basis given the large amount of share issuance, for example in early 2009.

TGR: Pinetree invests in junior exploration and development companies because they represent superior returns, but with that comes higher risks. How does Pinetree minimize these risks?

CS: Our portfolio consists of a large number of holdings diversified among stage of exploration and/or development, commodity focus and geography.

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