Investors commonly assume that rising interest rates adversely impact the gold price. The intuition is that if interest rates rise, this makes gold less appealing to own than interest-bearing assets. Such reasoning prompted Dominic Schnider to tell CNBC reporter Ansuya Harjani that he expects the price of gold to continue to fall as investors prepare for a rising Fed funds rate.
But this intuition is historically unfounded: A rising Fed funds rate has, more often than not, coincided with rising gold prices.
This is exemplified by gold’s bull market in the 1970s. From 1971 through 1974, the Fed funds rate went from roughly 5 percent to 10 percent, during which time the price of gold rose from $35 per ounce to roughly $200 per ounce. The Fed funds rate fell back to 5 percent by 1975 as the price of gold fell by nearly 50 percent. The Fed funds rate soared from 1977, peaking at more than 20 percent in 1980, and during that time frame, gold reached a peak of $850 per ounce.
If we look at the modern-day bull market, we similarly see strength in the gold price as interest rates rose from 2004 through 2007, and we saw gold hit its major $1,000 per ounce peak just as the Fed funds rate began to plummet.
What Schnider and other like-minded economists are missing is that when the Fed funds rate falls, this creates a carry trade whereby banks can borrow cheap money from the Fed in order to buy assets with higher interest rates such as U.S. Treasuries, corporate and municipal bonds, and stocks. It also incentivizes them to borrow cheap money from the Fed to lend to consumers who wish to buy homes and cars.
In a nutshell, when interest rates fall, the interest on interest-bearing assets becomes more attractive by comparison. A corollary of this is that assets that do not have any yield (i.e., gold and other commodities) become less attractive from an investment standpoint.
Similarly, as interest rates increase, this makes all interest-bearing assets less appealing. For instance, a bank can make money if it borrows money from the Fed at 5 percent to buy an asset yielding 5.5 percent.
But if the Fed raises its benchmark rate to 6 percent, that bank suddenly has to sell the asset-yielding 5.5 percent or else it is losing money on the trade. In this scenario, assets that have intrinsic value that doesn’t come from a coupon or dividend (i.e., gold and other commodities) become more attractive investments.
Ultimately, we can conclude that a high interest rate should indicate to investors that they should sell their gold, but a rising interest rate is a tailwind that will drive the gold price higher. Similarly, a low interest rate is an indication that investors should buy gold, whereas a lowering interest rate acts as a headwind. It follows that the best time to buy gold is when rates are low but set to move higher, and the best time to sell gold is when rates are high but set to move lower.
We can debate the future movements of the Fed funds rate until we are blue in the face, but the fact remains that Schnider’s conclusion is the complete opposite from that which logically follows from his assumption that interest rates will rise.
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