Dispelling the Myth of Gold and Interest Rate Hikes

The Federal Reserve recently approved a second interest rate hike for 2017. Additionally, they signaled plans to reduce their $4.5 trillion balance sheet. Essentially, these plans add up to a departure from the easy money policy that has reigned in recent years.

During times like this many investors question the value of precious metals as an investment. The reason: as interest rates increase other interest-bearing investments like bonds and dividend-paying stocks also raise their rates. This move increases the opportunity cost of gold. That is, allocating one dollar to gold means foregoing the opportunity to put that same dollar to work with one of these bonds or dividend stocks.

However, does the data agree with the popular sentiment that rising rates means falling gold?

In short, the answer is no. Between April and November of 2004, as the Fed repeatedly raised rates gold exhibited a similar pattern of a gradual rise. This one example serves as a reminder that conventional wisdom lacks wisdom.

The broad belief that a negative correlation exists between gold and interest rates is simply false. Case in point: from 1970 to 2015 the price of gold and interest rates experienced only a 28% correlation. Moreover, periods of surging gold prices have been characterized by similarly aggressive rate hikes. Throughout nearly all of the 1970's, interest rates quadrupled while gold made an incredible journey from $50 an ounce to $850 an ounce.

The surprising durability of this myth is problematic for two reasons. First, it misdirects investor’s buying decisions. Second, the mere presence of the myth distracts from the clearer truth; gold prices fluctuate based on marketplace demand.

This myth is, unfortunately, likely to persist despite that on the heels of the Fed’s latest decision gold prices have risen. This jump in price stems from renewed fears about the health of the U.S. economy. Though the Fed’s move inspires some confidence, recent metrics are casting doubt on the likelihood that the Fed will approve a second hike in September. “Right now the market is doubting they’re going to be able to do a hike in September. That’s because U.S. economic data has been weak,” remarked a senior market strategist at RJO Futures.

The larger picture may portend a market correction thereby boosting demand for gold further. The easy money policy of the Fed has emboldened and empowered investors to commit more money to the equities market. Why? Because as the government purchases bonds investors migrate to investments with a greater return (albeit at a higher level of risk).

These inflows have been driving up stock prices to levels which some contend are outsized relative to the inherent value of the underlying assets.  As policymakers resolve to remove this support the stock market may experience outflows causing share prices to drop. “Don't be mesmerized by the blue skies created by central bank QE and near perpetually low-interest rates. All markets are increasingly at risk,” remarked the co-founder of Pacific Investment Management Company.

Investing often means challenging assumptions and questioning norms. As major economic policies shift revisit your preconceived notions and consider how your portfolio could be improved.