When the economy is booming, companies make profit and these profits are passed on to investors through dividend. This makes the stock market attractive, but when the economy is subdued and confidence is low, investors turn to gold because it is seen as a safe haven. The government increases interest rate when the economy is booming as funds are attracted to the stock market because of higher returns. In order to compete for those funds, governments offer higher yields on their bonds and banks offer higher savings rates. When the economy is slowing, the government decreases interest rate in order to stimulate consumption.
Gold and interest rates are negatively related through inflation. Interest rates have a positive relationship with inflation. Higher interest rate will induce higher inflation. When US Federal Reserve raises its key interest rate, bonds will pay higher interest rate.
Gold, however, has no yield. It does not pay any interest so investors will sell gold and buy bonds or dividend paying stocks. So conventional wisdom says that higher rates are bad for gold. The last time such a relationship existed was in 1980. If we look in isolation, gold often thrives during the Fed’s rate hike cycles.
The US is currently the only major economy where interest rates are expected to rise. In contrast, major gold consuming nations are still heading in the opposite direction. In July, HSBC’s global research team published research showing that the price of gold has increased after the last four Fed rate hikes. During the bull market run in gold in 2000, interest rates declined significantly and gold prices rose. But there is no direct evidence of co-relation between gold and interest rate because gold prices peaked well in advance before the change in interest rate. When interest rates were kept pressed to nearly zero, the price of gold still corrected downwards.
Going by the conventional market theory on gold and interest rates, gold prices should have continued to soar since the 2008 financial crisis. When the US Fed increased interest rate from 1% to 5% between 2004 and 2006, gold prices soared by an impressive 49%. Gold again is off to a good start in 2017, just like in 2016. It is nearly up by 8% despite the rate hike in December 2016 similar to the rate hike in December 2015. It jumped 13% in the two months following the last increase in December 2015.
So, we can conclude from the historical data that gold prices should move in the opposite direction of interest rate but it doesn’t always.
The writer is director, Tradebulls Securities