Will It Be Over For Gold When the Fed Raises Rates?

I wish I had a dollar for every time I’ve been asked this question. But, today, I’ll get right to it. If I were to use recent history on which to base my answer, then no, it won’t.

How can I make that claim? After all, loyal readers of the Daily Pfennig® newsletter know that past performance is no guarantee of future results, and that higher interest rates are said to be bad for gold. Once rates start to move up, holding gold gets less attractive. Gold doesn’t pay interest, so investors sell it to buy interest-bearing assets when rates offer higher returns.

At least that’s the traditional wisdom. And, since it’s repeated ad nauseam by every journalist, economist, and TV pundit around, it must be true, right?

Not necessarily, because it overlooks a key part of the picture.

Interest Rates vs. Gold
First, let’s look at the long-term picture of gold and interest rates. This chart shows the gold price and the 10-year Treasury rate without adjustment for inflation over the past 45+ years.

Fig. #1
Gold & Nominal Interest Rates

Source: EverBank Research Team, based on an analysis of publicly available data from Thompson Reuters.

Notice that when rates soared in the late 1970s, so did gold.

On the other hand, interest rates were on a downward trend throughout the 2000s – yet gold climbed dramatically. You’ll also see periods where rates and gold fell simultaneously.

The bottom line is that there is no absolute correlation between gold and nominal rates. There must be something else at play, but what?

Gold And The Real Interest Rate
Let’s talk now about the impact of the real interest rate – in other words, the rate after accounting for inflation.

If you earn 2% on an interest-bearing investment and inflation is 1%, your real return is +1%. On the other hand, if your investment earns 1% but inflation is 2%, your real rate is -1%.

This calculation is the same regardless of how high either rate may be: a 15% interest rate and 13% inflation still nets you 2%. This is why high interest rates are not necessarily negative for gold; it may be that the real rate has a more direct impact on what gold does.

Here’s the same chart as above – except with the real interest rate (10-year Treasury rate minus CPI inflation).

Fig. #2
Gold and Real Interest Rates

Source: EverBank Research Team, based on an analysis of publicly available data from the St. Louis Federal Reserve and Thompson Reuters.

Notice the periods when the real rate was below zero: gold was in a staunch bull market. This included the mid-1970s, late 1970s to early 1980s, and the periods 2009 and 2011, where the gold price increased each time.

And, when the real rate was positive? You’ll see this includes, among others, the period beginning 2013, which is when the gold price coincidentally began its current bear market. And, with real rates still positive in recent months, gold has continued to struggle.

One reason gold and real interest rates might vary together is as follows: when real interest rates are at or below zero, cash and bonds actually lose purchasing power, regardless of what the investment pays. On the other hand, when the real rate is positive, investors may shift to interest-bearing assets, because they provide a positive return vs. gold.

Let’s zoom in on a period where the real rate was above 2% for a prolonged time.

Fig. #3
When Interest Rates Exceed Inflation, Gold Is Usually Weak

Source: EverBank Research Team, based on an analysis of publicly available data from the St. Louis Federal Reserve and LBMA.

For the 18-year period between 1982 and 2000 where real rates were above 2%, gold was essentially flat to down. There were short periods when it rose and dropped significantly, but over the span of the positive rate environment, the gold price suffered.

The Coming Rate Hike vs. Gold
So, what will happen to gold when the Fed does raise rates?

As the formula suggests, it may depend on what inflation is at the time of the rate hike. Will the consumer price index (CPI) be above or below the 10-year Treasury?

However, we also have data on how gold has historically reacted to a rate hike. Here are the four primary rate increase periods since the mid-1980s, along with gold’s response.

December 1986: In the six months following the rate hike, gold rose 25% and trended up the next few years.

February 1994: The gold price was volatile all year and ended down, but was up 2.6% by the end of September. It trended down over the next decade.

June 1999: This was the first of three rate hikes over the next six months. Gold initially dropped after the first two, but by the third hike six months later, the price had risen 13.5%. It was relatively flat the next few years until it began its historic climb in 2001.

June 2004: Four rates hikes occurred over the next six months. Gold was 13% higher by December 1 and continued its historic run until around 2011.1

In the major rate hike periods over the last 40 years, the gold price was higher six months later, but the years that followed don’t track a particular pattern. In other words, it probably won’t be over for gold when the Fed raises rates – history says prices may actually move higher at that point, at least in the short run.

It’s worth pointing out that in the months leading up to each hike, gold fell, likely due to investors selling in anticipation of the rate increase.

That’s possibly what’s going on now, too. The media has bombarded us with speculation of a potential rate increase for many months – and gold has continued to be weak. At this point, the rate hike is likely already priced in, just as it was in the four examples above.

Implications For Investors
1) The first message to gold investors is to not fear an interest rate increase. Gold prices have historically risen, in the short term, soon after a rate hike period begins.

2) Remember to watch the real rate, not just the nominal rate. Historically, as real rates have turned negative, gold has tended to begin, or already be in, a bull market.

3) Regardless of the constant chatter about rates, keep in mind the real reason you own bullion: as a store of value and a hedge against crisis, including inflation and even deflation. If we experience any kind of financial chaos – and the risks for such are arguably very high right now – then gold could respond and help provide the kind of wealth protection it has tended to provide throughout history.

In other words, don’t be discouraged just because real rates are positive. You own gold because you want a long-term store of value that will help insulate you against many forms of financial turmoil. Gold is one of the few assets that has a history of doing just that.

Until the next Daily Pfennig® edition…

Tim Smith
Vice President
EverBank World Markets, a division of EverBank