Here is the Proof, Rising Interest Rates are Good for Gold
$GLD, $USD, $XAUUSD
You will recall that when the Fed raised interest rates in December, and the publicly spoke its plan to do so 3X more times in Y 2017, the conventional wisdom suggested gold should fall.
The theory: Gold is a non-yielding asset, the cost of holding it increases as rates rise. Hang on, theory does not always convert in practice.
Since the Fed’s December rate hike decision, Gold is up about 8%, that is no anomaly.
The Big Q: Why?
The Big A: Here’s why, Gold is among the best performing assets in a rising rate environment, aka “hiking cycle.”
HeffX-LTN’s research shows that Gold’s performance for 1 year on either side of rate hikes was stronger than when rates remained unchanged.
Although Gold performs well when rates are rising, higher rates themselves are not the reason. The catalysts for higher Gold prices are the conditions leading to the hikes, inflation, and economic growth
We all know the Fed sets the direction of interest rates. To meet their dual mandate, they must be reactive, that means basing their decisions on hard data. In the past, they have raised interest rates when inflation is climbing.
This chart shows how the Fed has adjusted interest rates based on inflation.
Gold is the ultimate inflation hedge and therefore it tends to rise as rates are moving higher.
But, eventually higher rates impact Gold’s performance. This is the reason it performs better in the early stages of a hiking cycles, as early rising inflation offsets initial rate hikes. As the cycle matures and positive real rates emerge, then Gold becomes less attractive.
Yes, there are also other factors that affect Gold prices in these scenarios.
Higher rates tighten financial conditions, which in turn weigh on economic activity. These conditions lead to a less “pro-growth” environment, which makes Gold more attractive as bonds and stocks stall, pull back correct and consolidate.
Another aspect affecting Gold’s price is the USD.
Gold and USD have a strong inverse correlation, meaning when the USD rises, Gold falls, and vice-versa. Therefore, understanding the link between interest rates and USD is Key.
As the above table shows, the jury is still out on this relationship.
Which direction the USD moves during cycles depends on a lot of outside factors. These factors include global central bank policies and the relative attractiveness of US markets.
Inflation and the strength of USD are the biggest determinants of where Gold prices go.
So, what does the current setup look like for the precious Yellow metal?
The recent uptick in inflation is positive for Gold.
In December, the CPI (consumer price index) recorded 2.1% Y-Y growth. Expected inflation, measured by the 10-year breakeven rate, is consolidating above 2%. Both numbers are at their highest marks since Y 2014.
The Key Q, can it last?
A major factor will be when the pro-growth policies President Trump are enacted. If the post-Election inflation boost is to continue, successful design and implementation of his policies must happen soonest.
Based on data released on Friday, 24 February 2017 the core inflation rate, stripping out volatile food and energy categories, is running at 2.3% annually, above the Fed’s 2% target and at the highest mark in more than 2 years.
In reaction, the fed-fund futures market, moved from a 20% to 40% chance of a rate hike at the meeting in March, however I do not see a rate hike until the June meeting if then.
With that Gold initially sold-off, it quickly rebounded and finished higher on the day, trading at 1258.20 oz., again proving its resilience when faced with the prospects for higher rates.
However, given the indebtedness of the US and its anemic growth, this tightening cycle will likely be more protracted and remain accommodative to the Trump Administration’s policies.
The Fed’s dovish stance, as conveyed in last months meeting minutes, confirms this. If so, positive real rates will remain low, that is good for Gold.
The USD is the other big determinant of Gold’s price direction. After hitting a 14-year high in December, USD went on to have its worst January since Y 1987.
Where USD goes will depend partly on the actions of other central banks.
Today, one can earn 2.31% investing in a US 10-yr T-Bond or .33% in the German equivalent. Given this spread and instability in other major global economies, inflows into US assets will continue, thus pushing USD higher.
However, as markets are moving on political news and a strong USD is not sounding like part of President Trump’s agenda, we should pay close attention to the DC chatter.
Note: Watch for Gold prices and bond yields rising in tandem. In the past, this has signaled higher inflation and stock market volatility. This combination preceded both the Y’s 1973–1974 and Y 1987 stock market corrections.
That being the case and given the current setup and macro environment, owning Gold looks prudent no matter which way this cycle plays out.
If the Fed stalls again as it did in Y 2016, it may further reduce confidence in its forecasting ability, thus making another case for higher Gold prices.
“Gold is money. Everything else is credit.”– JP Morgan
We are in the largest credit expansion in history, having the precious Yellow metal in a balanced portfolio is essential.
It is your money, it is your responsibility.
Have a terrific weekend.
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