Gold In Fed-Rate-Hike Cycles

The epicenter of gold’s intractable weakness over the past couple years has been the Federal Reserve’s upcoming rate-hike cycle.  Everyone assumes higher interest rates will devastate zero-yielding gold, leaving it far less attractive.  This premise led investors to avoid gold like the plague, and speculators to short sell it at wild record extremes.  But provocatively, history proves gold thrives in Fed-rate-hike cycles.

It’s easy to understand how the Fed’s first rate-hike cycle in over 9 years has cast a pall over traders’ gold outlook.  While gold’s unique attributes make it exceptionally valuable for portfolio diversification, it generates no cash flows.  Gold will never pay dividends or interest, which makes it a sterile investment.  Presumably demand for yield-less assets will wane as rate hikes naturally force yields on bonds higher.

While this bearish gold thesis sounds perfectly logical, its core assumption is fatally flawed.  While gold has never offered a yield, investors all over the world have still flocked to it all throughout history.  They certainly weren’t looking for a yield play, and bought gold to take advantage of its formidable strengths on other fronts.  If yield had ever been this metal’s dominant attribute, gold would indeed be essentially worthless.

While gold was infinitely outgunned on yields by literally everything that pays one, it still blasted 638% higher in the decade ending in August 2011.  These returns were vastly superior to the dividend-heavy S&P 500, which slid 1.9% over that same 10.4-year span.  While yielding absolutely nothing, gold still skyrocketed 2332% higher in the decade ending in January 1980!  Bond yields were crazy-high then too.

Gold has never been a yield play, and never will be.  The widespread antipathy towards this leading alternative investment today on the idea that rising rates will slaughter it is simply a flimsy rationalization of popular bearishness.  Consider how silly this yield-trumps-all notion would be in the stock markets, where plenty of the hottest and most-adored stocks like Amazon and Netflix have never paid dividends.

Dividend-less stocks are sterile investments just like gold, yet Wall Street fawns on them.  Just like gold, their prices are determined by the intersection of trader supply and demand that has nothing to do with their zero-yielding nature.  Have you ever heard anyone argue that higher prevailing interest rates are going to devastate stocks that don’t pay dividends?  Of course not, and that notion is just as tenuous applied to gold.

So rather than blindly accepting today’s groupthink belief that gold is doomed in the Fed’s upcoming rate-hike cycle, why not check the historical record?  While this uber-dovish Fed hasn’t raised interest rates in many years, there have still been plenty of Fed-rate-hike cycles in modern history.  So how has zero-yielding gold performed during these past central-bank tightenings?  Are rate hikes really a threat to gold?

To find out, I downloaded nearly a half-century of daily Federal Funds Rate data directly from the Fed itself.  This FFR is the primary interest rate the Fed directly controls, what it sets its policy target for when it hikes or cuts rates.  The federal-funds market is where banks lend and borrow cash deposits on an overnight basis that they hold at the Federal Reserve.  Most other interest rates key off the Fed’s FFR.

In a mind-numbing exercise of tedium, I looked at every decision by the Fed’s Federal Open Market Committee that sets the federal-funds-rate target since 1971.  And there were a lot of them, the FOMC changed its federal-funds-rate target 251 times in the 46 years since.  I found that high number pretty surprising.  The FOMC holds 8 policy meetings per year, equating to around 368 over that entire span.

That implies the FOMC either hiked or cut the FFR at over 2/3rds of its meetings, which seems way too high.  And it probably is, since the FOMC sometimes chooses to change rates between meetings when volatile market conditions sufficiently frighten its members.  But there has been an abundance of Fed rate hikes over the past half-century, a large sample size to see how zero-yielding gold has fared in their midst.

Since investors and speculators today are very worried about how gold will perform in a sustained Federal Reserve rate-hike cycle, I ignored isolated FFR hikes surrounded by cuts.  Since 1971 the Fed has made 6 lone rate hikes bracketed by cuts.  And there were 6 more episodes where the FFR was raised two times back-to-back but was then reduced again.  One or two isolated hikes certainly don’t make a cycle.

I decided to generously define a Fed-rate-hike cycle as 3 or more consecutive increases in the federal-funds rate with no decreases.  These rate-hike cycles start at the Fed’s first rate hike, and end at the Fed’s last rate hike before it starts cutting rates again.  By this 3-or-more definition, the Federal Reserve has executed 11 rate-hike cycles since 1971.  Gold’s performance in these is critical for its outlook today.

While this red daily federal-funds-rate data is directly from the Fed itself, it looks a lot more volatile than most would expect.  This is because the FFR is technically a free-market interest rate determined by the federal-funds supply and demand from commercial banks.  The FOMC doesn’t actually directly set its FFR, instead it sets a target level which it then attempts to achieve through its own federal-funds buying and selling.

For each Fed-rate-hike cycle, 4 key metrics are noted.  Each cycle’s total federal-funds-rate increase in basis-point terms is shown in red, followed by the number of separate hikes it took the Fed to complete.  That’s followed by how long each rate-hike cycle took in months in white.  And last but not least is gold’s price reaction over the exact spans of the Fed’s rate-hike cycles in blue.  This really defies prevailing consensus.

If the Federal Reserve’s rate-hike cycles were indeed gold’s arch-nemesis, this zero-yielding sterile asset should have been hammered in the great majority of them.  Instead gold actually rallied through 6 of the 11 modern Fed-rate-hike cycles!  And at average gains seen within these exact rate-hike-cycle spans of a staggering +61.0%, gold did amazingly well.  Gold often didn’t just weather rate hikes, but thrived in them!

And in the other 5 Fed-rate-hike cycles where gold indeed lost ground as everyone expects today, the losses were comparatively moderate.  The average losses over these exact rate-hike-cycle spans were just 13.9%.  While those are major losses, they are still a far cry from the gold death spiral that investors and speculators seem to be expecting in the Fed’s next rate-hike cycle.  Gold has proven very resilient.

And even though investors and speculators have notoriously short-term memories, it’s inexcusable that they can’t at least look to the Fed’s last rate-hike cycle to see how gold performed.  Between June 2004 and June 2006, the Federal Reserve raised its benchmark federal-funds rate by a total of 425 basis points in 17 separate hikes!  This more than quintupled the FFR from 1.00% at the start to 5.25% at the end.

That last rate-hike cycle was exceptionally intense.  It was the first since the extreme rate hikes of the 1970s with over 10 hikes, over 400 basis points of hiking, and lasting over a year.  So if there was ever a modern rate-hike cycle that should have obliterated gold as everyone expects today, that last mid-2000s one was sure it.  Since gold yields nothing, demand for it should’ve cratered if that argument is correct.

Yet what happened?  Gold surged 49.6% higher within that exact Fed-rate-hike span!  That’s a heck of a rally in two years, trouncing the benchmark S&P 500 stock-market gains of just 12.0% in that same timeframe.  And those strong gold gains happened while the federal-funds rate soared all the way back over 5%.  This naturally catapulted bond yields much higher, which traders argue should’ve destroyed gold demand.

And provocatively, that last rate-hike cycle was more extreme in every way than the Fed is telegraphing its next one will be.  The federal-funds rate has been at zero continuously since December 2008 when the FOMC panicked in response to that year’s epic stock panic.  Fed officials are very worried about the liftoff from ZIRP sparking a major selloff in the US equity markets, so they are planning very slow hikes.

After every other FOMC meeting, the Fed publishes the economic projections of FOMC voting members who actually set the FFR target levels along with the presidents of the regional Fed banks.  And at its recent mid-June meeting, the latest projections by the Fed officials who make these decisions put the FFR around just 1.5% in 2016, 3.0% in 2017, and 3.5% over the “longer run”.  That frames these coming rate hikes.

If the FOMC gradually raises its FFR target from today’s 0.0% to 3.5% over the next couple years, we are looking at 350bp of hikes.  At 25bp per hike which is exactly what the Fed did in the mid-2000s, this would take 14 hikes.  Such a rate-hike cycle would be less extreme than the last one in every way, including the total FFR increase, the duration of the tightening cycle, and the number of individual rate hikes.

And I suspect this coming rate-hike cycle will prove even more moderate than that.  This uber-dovish Yellen Fed is already implying a “one-and-done” strategy.  The FOMC is so worried about triggering an adverse market reaction that it doesn’t seem to want to keep hiking rates at every meeting.  Instead it will likely spread the rate hikes out, skipping meetings.  That makes for a much-shallower trajectory of rising rates.

On top of that, Fed officials’ future federal-funds-rate projections have proven wildly optimistic for years.  The Bernanke Fed started releasing these projections at every other FOMC meeting back in April 2011, in order to promote transparency.  They started including FFR projections in January 2012.  And back then, these elite Fed officials forecast the federal-funds rate averaging 4%+ after 2014!  That was sure wrong.

The key point here is since gold rallied so strongly in that last major rate-hike cycle in the mid-2000s, it should have no problem rallying again in the far-milder coming rate-hike cycle.  And provocatively, gold has actually done the best in the most extreme rate-hike cycles in modern history.  The most extreme on record by every metric ran over 34.6 months ending in October 1979, where the FFR was hiked 32 consecutive times!

And that was for a mind-boggling total FFR increase of 1075 basis points.  With the federal-funds-rate target skyrocketing all the way up to 15.5% in that mother of all rate-hike cycles, the yields on bonds were off-the-charts high.  So if there was ever an ideal case for higher yields sucking all the capital out of gold investment, that was it.  By traders’ rationale today, gold should’ve plummeted into the abyss in that cycle.

Yet it did just the opposite, rocketing 178.3% higher over the exact span of those Fed rate hikes!  And that wasn’t a fluke either.  There was another extreme rate-hike cycle running over 17.4 months ending in August 1973, where the Fed hiked 21 times in a row to catapult the FFR 600bp higher.  And again instead of collapsing as traders today would assume, this metal soared 113.1% higher over that very span.

Obviously something other than yields is driving gold demand!  If gold was merely the yield play that all the legions of bears wrongly assume today, it would’ve been annihilated during those extreme rate hikes of the 1970s.  But instead it skyrocketed, making gold bulls rich beyond their wildest dreams.  Gold blasted an astounding 2332% higher over a decade where the Fed hiked its FFR target from 3.5% to 14.0%!

Investors flocked to gold so aggressively in that extreme-rising-rate environment that they fomented a popular speculative mania in it.  Provocatively 2 of the 5 rate-hike cycles where gold actually fell were in the immediate aftermath of that parabolic gold surge and inevitable subsequent collapse.  A third rate-hike cycle where gold lost ground happened in the mid-1970s after another episode of incredible gold strength.

So did the fourth and fifth ones in the mid-1980s and late 1980s.  So out of the 5 Fed-rate-hike cycles where gold has actually fallen, all happened just after major secular gold highs.  Gold has never fallen in a Fed-rate-hike cycle when starting from low levels.  And since gold just slumped to a brutal 5.5-year secular low on that extreme record shorting attack by American futures speculators, it sure isn’t high today.

So the evidence of history overwhelmingly supports just the opposite of what prevailing wisdom argues today.  Rather than Fed-rate-hike cycles being super-bearish for zero-yielding gold, they have actually proven very bullish for it!  The smart high-probability-for-success bet to make is that gold prices will surge during the Fed’s upcoming rate-hike cycle.  Odds are gold is on the verge of a major rate-hike upleg.

But how can that be?  Gold yields nothing, zero, zilch, nada.  It’s a “barbarous relic”, an anachronism with no place in modern portfolios.  Why on earth would any investor want to buy gold when they could instead own a great American company like Netflix trading at 237x earnings, or US Treasuries yielding 2.2%?  Did I mention gold pays no dividends or interest?  The Wall Street Journal recently called gold a “pet rock”.

The reason gold investment demand soars in rising-rate environments is actually quite simple.  Fed rate hikes have serious adverse impacts on stock and bond markets, which is the very reason the FOMC has fearfully kept ZIRP in place for an unbelievable 6.7 years now!  When the Fed initially went ZIRP for the first time in its 95-year-history at that point, it swore up and down that ZIRP was a temporary measure.

Rising rates are devastating for stocks, especially if the stock markets are high and overvalued, for multiple reasons.  Higher-rate environments lead to lower overall demand throughout the economy as debt-service costs climb for everyone.  And lower demand leads to slumping corporate sales and profits, which ramps up price-to-earnings ratios to make already-overvalued stock markets look even more expensive.

The main mechanism through which the Fed’s ZIRP has worked to directly levitate the US stock markets is through corporate stock buybacks.  American companies haven’t been able to grow sales in this weak US economy, so they’ve instead taken their excess cash and bought hundreds of billions of dollars of their own stocks.  They doubled down on these stock buybacks by borrowing hundreds of billions more.

When the Fed rate hikes kill ZIRP, borrowing costs for corporations will rise which will make borrowing money to buy back stocks far less attractive and viable.  When the torrent of ZIRP-financed buybacks slows, the dominant source of stock demand in recent years will wane.  That will make the stock markets very susceptible to a long-overdue bear-market-grade selloff.  Higher rates are super-dangerous for stocks.

Since bond yields will rise in concert with the federal-funds rate, bonds will become more competitive with the big blue-chip companies that pay healthy dividends.  These stocks are yield plays, so they will see serious selling as bond yields eclipse their dividends.  Fed-rate-hike cycles are very damaging to stock markets, especially overvalued and overextended ones, in a variety of direct and indirect ways.

And existing bonds will fare even worse.  As prevailing interest rates rise thanks to the Fed’s upcoming rate-hike cycle, existing bonds will be sold off until their prices are low enough for their fixed coupon payments to equal the new higher yields.  That means every rate hike will lead to losses in principal for bond investors, something most of them consider unacceptable.  Bonds get crushed when rates are rising.

With both stocks and bonds suffering serious selling pressure when the Fed is in a tightening cycle, gold really shines.  This alternative investment generally moves counter to the stock markets, so when they are weak is when investors rush to park capital in this safe-haven asset.  Gold not only holds its value as stocks and bonds fall, but appreciates as investment demand for it ramps dramatically with stocks suffering.

Historically gold fares the best when the stock markets are faring the worst.  And that’s likely never going to change.  If this upcoming Fed-rate-hike cycle seriously weighs on the stock markets, which is all but guaranteed in light of their lofty overvalued levels today, gold investment demand is going to grow dramatically.  Thus there are nearly-certain odds gold will surge again during the Fed’s next rate-hike cycle.

And the biggest gains to be won when gold returns to favor are not in this metal itself, but in the beaten-down stocks of its miners.  Gold’s recent record-extreme futures shortig attack sparked a full-blown panic in gold stocks, leaving them at fundamentally-absurd price levels. While they’ve rallied off those epic lows, their massive mean-reversion higher to righteous prices is only just beginning with far bigger gains to come!

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The bottom line is Federal Reserve rate-hike cycles are not bearish for gold as is widely believed today.  Gold has risen in more rate-hike cycles than it has fallen, and the more extreme the rate-hike cycles the greater gold’s gains.  Gold surged dramatically in the last rate-hike cycle in the mid-2000s, and rocketed higher during the most extreme rate-hike cycles in history in the 1970s.  Higher rates are actually bullish for gold.

Contrary to the popular myth, gold is not and has never been a yield play.  Investors diversify capital into gold when conventional stock and bond markets are weak.  And Fed-rate-hike cycles hurt stocks and bonds on multiple fronts, greatly ramping investment demand for gold.  With today’s stock markets so high and gold so low as the Fed’s next rate-hike cycle begins, gold’s next upleg is likely to prove massive.

Adam Hamilton, CPA

September 4, 2015

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