How Gold Will React To Interest Rates


Just as an apocalyptic asteroid venturing inwards in the Solar System to root around in the very near vicinity of Earth creates a great deal of hand-wringing and posturing, there's been no shortage of speculation about the fate of precious metals and currencies should the Federal Reserve decide to raise interest rates on US dollar borrowing this year.  Like an apocalyptic asteroid, there's no certainty about when the Fed move could occur or how it will impact the market once it takes hold.  There's a good amount of agreement that such a move lies on the horizon, however, with a Wall Street Journal survey of economists revealing that the majority believed the rate hike would occur in autumn of 2015.  Whenever interest rates rise, whether they be tomorrow or a decade from now, how will precious metals, and particularly gold, react?

Recent Performances

Just about anyone who has ever ventured onto the Internet to find information about gold has been told that the metal acts as a hedge against inflation.  That fact represents a staple lesson of Commodity Investment 101 but nevertheless comes laden with about as many asterisks as a credit card billing statement.  Gold can act as a hedge against inflation provided first and foremost that inflation brings down the value of the dollar.   Gold does little to appreciate in value in a market with very little inflation and very little interest on the dollar -- like, say, the past five years of the American economy -- due to the fact that nobody wants a hedge against inflation when there's no inflation.  Without a weak currency to trade against, gold has risen and fallen but remained at or near the $1200 per-ounce figure for the past half-decade. 

Monetary Policy

Following the 2008 recession, the Federal Reserve decided to slam on the brakes of interest in order to free up as many possibilities for banks and lending institutions to facilitate borrowing and spending to get the economy out of the largest hole since that of the Great Depression.  The policy to ensure that any American can borrow money and pay next to nothing in terms of interest created a boom market for commodities, which have the tendency to grow in value each time they change hands, in addition to dropping out the bottom of the bond market.  The boom market peaked for nearly every commodity, hard and soft, between 2008 and 2010.  With only a few exceptions, most interestingly iridium, it's all been a downhill slide for commodities since then on the wave of free money entering into the global spending pattern.  The unprofitability of many such commodities have forced some mining companies out of business or into drastic restructuring.  As the Federal Reserve sought to preserve the dollar's buying power rather than gold's value (even with the worlds' leading gold reserve holding, only ten billion dollars of the US' $17 trillion GDP lies in bullion), gold and gold investors took it on the chin with next-to-no interest rates.  As interest rates appear about to change, so too will the prospects of gold change with them.

Rules And Exceptions To Rules

Chart out the performance of gold relative to the performance of the dollar index and you'll find a rather surprising negative correlation -- as one goes up, the other very often goes down.  In the investment world, however, "very often" doesn't ensure accumulation of wealth.  In 1999, at the height of the dot-com bubble, the Fed raised interest rates in particularly draconian fashion in order to mitigate the one-way flow of money to start-ups.  While the dollar's value rose, gold saw steady growth in demand during one of the greatest periods of global economic prosperity in history, effectively allowing the metal to go undisturbed.  From 2004 to 2006, furthermore, the Fed enacted its famous "tightening" policies that raised the interest rate by no less than 5.25%, but gold gained some 60% in that same time frame.  The complexity of the global gold market means that the dollar index proves to be the leading influence, but by no means the sole influence.  If there's a near-certainty that other commodities (most notably oil) will grow thanks to higher interest rates, the likelihood of gold growth can be chalked up as a mere somewhat-certainty.

Takeaway: Follow The Leaders

When you're wondering how a commodity will perform in the immediate future, there's one good indicator of performance: the companies that stand to profit the most (or least) from a major change.  In this instance, it's worth looking at major gold mining operations to see if they'll ramp up operations or sit tight on their output.  The June Comex gold futures price rose by $36 per ounce in the month of May to date, indicating good short-term performance.  In addition, the Market Vector Gold Miners (GDX on the New York Stock Exchange, trading for $23.96) has fallen precipitously.  Higher demand and lower supply is superb news for gold investors, but as with all things in life the good times may go as soon as they come.  A Kitco report noted that gold falls by an average of two percent in the month prior to an interest rate hike as investors shift their money from currency and commodities into bonds so that they can profit from a higher interest rates.  Here, the right move depends on how much your portfolio relies on gold as an engine for growth.  If you've got only a paltry percent of your net worth in gold, gold futures, or gold stocks, ride the high tide in the next few months and then drop the metal like a hot golden potato by the end of the summer.  If you're in gold for the long run, the interest rate hike represents a minor disturbance -- one that may very well be canceled out if the dollar underperforms following the hike, sending investors sprinting back to gold in order to get some of their lost value back again.

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