Here’s Proof Rising Rates Are Good For Gold

When the Federal Reserve raised interest rates in December—and then laid out a plan to do so three more times in 2017—theory suggested gold should fall. As gold is a non-yielding asset, the cost of holding it increases as rates rise. However, theory doesn’t always convert into practice.

Since the Fed’s decision, gold is up 7.5%—and it’s no anomaly.

Here’s why.

Gold Among the Best Performing Assets in Rising Rate Environments

Analysis from Morgan Creek Capital Management shows gold is consistently one of the best performing assets during hiking cycles.

Annualized Asset Return during Hiking Cycle (Gains/Losses Represented in %)

Source: vaneck.com

Our own research has thrown up comparable results. Gold’s performance for one year on either side of rate hikes was stronger than when they remained unchanged.

These findings run contrary to popular belief. So, what gives?

The Catalyst That Drives Gold Higher

Although gold has performed well when rates are rising, higher rates themselves aren’t the cause. The catalysts for higher gold prices are the conditions leading to the aforementioned hikes.

As we know, the Federal Reserve sets the direction of interest rates. To meet their dual mandate, they must be reactive—basing their decisions on hard data. In the past, they have raised interest rates when inflation is climbing.

This chart shows how the Fed has adjusted interest rates based on inflation.

Source: fred.stlouisfed.org

Gold is the ultimate inflation hedge and therefore it tends to rise as rates are moving higher.

To be clear, higher rates do eventually impact gold’s performance. This is the reason it performs better in the early stages of hiking cycles. In the early innings, rising inflation offsets initial rate hikes. As the cycle matures and positive real rates emerge, gold becomes less attractive.

Other Major Factors

There are also other factors that affect gold prices in these scenarios. Higher rates tighten financial conditions, which in turn weigh on economic activity. These conditions lead to a less “pro-growth” environment, which makes gold more attractive as bonds and equities falter.

Another aspect affecting gold is the US dollar. Gold and the dollar have a strong inverse correlation. This means when the dollar rises, gold falls—and vice-versa. Therefore, understanding the link between interest rates and the US dollar is crucial.

As the above table from Morgan Creek shows, the jury is still out on this relationship. Which direction the dollar moves during cycles depends on a multitude of outside factors. These factors include global central bank policies and the relative attractiveness of US markets.

As the analysis shows, inflation and the strength of the greenback are the biggest determinants of where gold goes. So, how does the current setup look for the yellow metal?

Current Outlook

The recent uptick in inflation is positive for gold. In December, the consumer price index (CPI) recorded 2.1% year-over-year growth. Expected inflation, measured by the 10-year breakeven rate, is consolidating above 2%. Both numbers are at their highest levels since 2014.

The Key Question Is Can It Last?

A major factor will be how much of his pro-growth policies President Trump can enact. If the post-election inflation boost is to continue, successful design and implementation of said policies must happen.

Based on data released today the core inflation rate, stripping out volatile food and energy categories, is running at 2.3% annually, above the Fed’s 2% target and at the highest level in more than two years. 

In reaction, the Fed-fund futures market, often used to predict the likelihood of Fed rate hikes, moved from a 20% to 40% chance of a rate hike at the meeting next month. 

While gold initially sold-off, it quickly rebounded and is now $7/oz. higher on the day, trading at $1232/oz., again proving its resilience when faced with the prospects for higher rates. 

However, given the indebtedness of the US and tepid growth, this tightening cycle will likely be more protracted and remain accommodative.

The Fed’s overall dovish stance, as conveyed in meeting minutes, confirms this. If so, positive real rates will remain low, which is good for gold.

The dollar is the other big determinant of gold’s direction. After hitting a 14-year high back in December, the greenback went on to have its worst January since 1987.

Where the dollar goes will depend partly on the actions of other central banks. Today, one can earn 2.4% investing in a US 10-year Treasury or .33% in the German equivalent. Given this spread and instability in other major global economies, inflows into US assets will likely continue, thus pushing the dollar higher.

However, as markets are gyrating on political news and a strong dollar is not sounding like part of Trump’s agenda, we should pay close attention to rhetoric out of Washington.

As a side note, watch for gold prices and bond yields rising in tandem. In the past, this has signaled higher inflation and impending stock market volatility. This combination preceded both the 1973­–1974 and the 1987 stock market crashes.

Gold Is A Smart Move, No Matter What Happens

Given the current setup and macro environment, we think owning gold is especially prudent no matter which way this cycle plays out. Although history does not repeat itself it does tend to rhyme and gold has performed well as rates have moved higher in previous cycles.

However, if the Fed stalls once again—similar to 2016—it may further reduce confidence in its forecasting ability, thus making another case for higher gold prices.

As American financier JP Morgan proclaimed 105 years ago, “Gold is money. Everything else is credit.” Amid the largest credit expansion in history, having gold in your portfolio is essential.