One of the factors that is most taken into account when forecasting the future behavior of the gold price is interest rates. For this reason, it is said that the metal market lives pending the decisions of the Federal Reserve, the body that determines the monetary policy of the United States. And gold, let’s not forget, is denominated in dollars, so it’s more influenced by that. In this post we are going to explain how this relationship works.
The basic principle is that gold and interest rates are inversely related , such that when rates go up, the price of gold goes down, and when rates go down, gold goes up.
Why is this supposed to happen? When interest rates rise is when the economy is doing well , consumers want consumer loans, companies expand their business, more cash is available and more spending is undertaken.
In these situations, central banks and financial institutions increase their profits, since they get a higher return on the money they lend.
What Does Gold Do When Rates Rise?
The theory goes that in times of economic prosperity, the attraction of a safe haven asset like gold diminishes. In addition, interest rates drive the currency (the dollar, in this case), so in the short term the price of gold falls.
This is a commonly accepted theory, although it is necessary to be precise: in times of economic prosperity, in many countries (especially in Asia), the consumption of gold increases, either in bullion or in jewelry, since citizens have a greater economic surplus.
It is also often said that gold falls when rates rise, since the so-called opportunity cost of owning the metal increases : that is, the investor earns more with other assets that offer higher returns thanks to the rise in interest rates .
This is the case, for example, of bonds, whose remuneration increases when interest rates rise, making them more attractive to investors than gold.
And When Do They Go Down?
Conversely, when interest rates fall, they reflect a situation in which confidence in the economy is reduced and growth slows.
This slowdown affects the cost of living, wage growth, employment and the value of the currency.
Investors are flocking to gold as a safe haven these days, for a number of reasons:
- It constitutes a protection of the patrimony against inflation, since it allows to maintain the purchasing power.
- It is the safe haven asset par excellence, since it does not entail responsibility on the part of anyone and has immediate liquidity , at any time and place.
The opportunity cost of owning gold instead of other assets is reduced as bond yields fall even to zero due to lower interest rates, so gold gains comparatively.
What Happens Right Now With The Types?
The Federal Reserve has decided in its last meetings to keep rates close to zero, due to the deterioration of economic indicators in the United States, due to the impact of the Covid-19 pandemic.
In fact, in one of his last public interventions, the president of this body, Jerome Powell , assured that the rates would remain at 0% until at least 2022 , since an economic recovery of the country is not expected before that date.
According to analysts, this is one of the reasons why the price of gold remains well above $1,700 an ounce these days.
By the way, the Federal Reserve’s decisions regarding interest rates during 2018 were the reason why the current president of the United States, Donald Trump, has repeatedly attacked the independence of this institution and its president (who was appointed by him himself), in a movement that has no precedent since the time of Richard Nixon, in the early 1970s.
The rate hikes dictated by the Fed in 2018 (from 1.25% in December 2017 to 2.25% a year later) irritated the president, who accused the Fed of not knowing how to react and of torpedoing the economy American.
The explanation is that rate hikes cause a competitive disadvantage for the US compared to its trade rivals, which is why Trump wanted rates to be as low as possible, which he has finally achieved, with the ‘collaboration’ of the pandemic.
The Falsity Of The Gold-Rate Correlation
Although, as we said, there is a general consensus on the inverse correlation between gold and interest rates, at various points in the last few decades the data has shown that gold does not follow the pattern of going down when interest rates rise.
Thus, between 1970 and 1980 , the price of gold rose 2,350% and it did so faster at times when rates rose, in an environment of high inflation. And between 1974 and 1976, when rates fell, gold did too , losing almost 50%. That is, they had a direct relationship.
It was later re-emphasized that gold and rates were not inversely related at all times: between 2001 and 2004, gold rose while the Fed lowered rates.
However, from 2004 to 2007, both the price of gold and interest rates rose. Between 2007 and 2011, gold reached its maximum historical price , in an environment of falling interest rates. And between 2011 and 2015, gold went down again, at the same time that rates did .
In other words, that this inverse relationship between the two is true sometimes and sometimes not. In general, the short-term trend is for gold to react in the way it is expected to react to rate movements. But when viewed in the longer term, that trend may change.
In any case, there is no doubt that interest rates are an important factor that contributes, among others, to the formation of the metal price.