Interest Rate Hikes Are Coming: What's Next For Gold?
On March 3, 2022, Fed Chairman Jerome Powell testified before the Senate banking committee. Powell is committed to lowering inflation by raising interest rates 25 basis points at the March 15-16 Federal Open Market Committee (FOMC) meeting. He is confident the economy is strong and can withstand the rate hikes despite the challenges presented by rising oil prices and the conflict in Ukraine. Additionally, Mr. Powell commented on supply disruptions lasting longer and making a larger impact on the overall availability of goods and services which attributed to how fast inflation has grown but firmly believes the rate hikes will not damage the labor market because of strong outlook and unemployment rates dropping to 3.8% in February.
The reason the Fed will raise interest rates to combat inflation is to slow down the speed of money. The idea is that making money more expensive will remove some buyers from the car, housing, and other debt-based purchase markets. Fewer buyers mean lower demand. Lower demand forces businesses to lower prices to attract consumers back to the market. The lower prices come at a high longer-term economic cost but provide some near-term financial relief across most sectors.
The best example was during the tenure of Fed chairman Paul Volcker (1979-1987). During the 1970s and early 1980s, inflation was in the double digits. Volcker raised interest rates to 20% in 1981. One of the first axioms they teach in economics classes, “there is no such thing as a free lunch.” Playing with interest rates is no exception. Raising interest rates brought consumer prices down but lead to a two-year recession and double-digit unemployment
It is widely believed that some predictable movements happen in different investment asset classes when interest rates rise. Typically, there is a correction in stocks and growth in the bond and other fixed income markets. This happens because companies sell at lower prices making less margin and having higher costs of capital decreasing profits. Investors rebalance their portfolios into safer assets like bonds and precious metals. The common belief is gold becomes less attractive to conservative investors so prices pull back because a bond will bring yield. Despite how common this thought is, it is only true sometimes.
According to Investopedia, the inverse correlation between rising interest rates and gold prices falling is only 28% which is not considered statistically significant. Contrary to what most people think, most of the time, there is a positive correlation or at least temporarily positive correlation that when interest rates rise so do gold prices. The environments that do show a higher correlation between rising rates and declining gold prices is raising rates from 0 but is inconsistent when rates are starting between 1-5%.
Instead of saying there is an inverse correlation between interest rates and gold prices, it is probably fairer to say there is a circumstantial correlation between the two. There is a strong correlation between interest rates and the stock market. If the market pulls back far enough, it will trigger the stop losses in automatic trading accounts (pensions, hedge funds, commercial investors, etc). Since the metals market is so highly leveraged and primarily priced in paper (futures contracts, ETFs, gold miners, etc.), a spike in automated sell orders will cause a temporary pullback in price. This pullback could last days, weeks, or even months, but is not permanent. After investors sell out of one market, they will reallocate their capital into different asset classes.
The most common reallocation strategies are moving into bonds, real estate, sometimes cryptocurrencies and, of course, precious metals. When the investors move from paper to wanting the metal in their safe, the prices tend to rise. A good example of this portfolio reallocation causing metals prices to spike is 2008-2011. The stock market was doing horrendous and real estate was a mess. However, gold more than doubled in a three-year period. When the Fed started ramping up quantitative easing, it was then that investors sold their gold and the price fell.
There is a possibility we could see a gold pullback with interest rate hikes, but the economy is in uncharted territory so there isn’t really a good playbook to follow. Interest rates don’t directly affect the price of gold as much as they affect the behavior of individual and institutional investors. Behavioral finance is a complicated blend of finance, economics and psychology taught in finance schools as a college major. It is not easily predicted in the short term. However, the long term is a different story. In a free market economy, market forces will correct prices and gold will receive a fair evaluation much higher than current levels. In a free market, gold is financial insurance and a good way to protect your purchasing power by hedging against inflation. If the government interferes too much in the market and it is no longer true to say it is a free market, then gold is there to protect you from the tyranny of government overreach and the risk of not physically controlling your wealth.
Whether the Fed raises rates or postpones, whether the price goes up or down, gold and other precious metals should be a part of every portfolio. Most investors aim for about 10-20 percent of their overall portfolio in metals. The best strategy is to keep buying gold at regular intervals to dollar cost average. Gold returns may not be as exciting as a big winner in the stock market, but that big winner can quickly become a big loser. With everything going on in the world, it is better to have gold and not need it, than need it and not have it. Do you agree? The U.S. Gold Bureau can be reached at (800) 775-3504.