There’s a lot of speculation at present as to the next move by the US Federal Reserve with respect to interest rates. Many are confident that the US economy is now on a solid growth footing and that higher interest rates are just around the corner. The Fed itself is conscious of not keeping interest rates too low for too long.
Of course, many ordinary US investors like retirees and those saving for retirement, have been hugely disadvantaged by the Fed’s low interest rate policies since the GFC. The value of savings has been wiped out due to inflation, with investors forced to chase higher-risk opportunities in the sharemarket and the property sector. This has led to greater risk taking and led to speculative bubbles in both shares and property.
A good example is recent Bloomberg data that shows that only twice in the past 25 years have new apartment buildings in the U.S. been constructed as quickly as they are right now. And that’s not necessarily a good omen. The first occasion during February 2000 was right before the dot-com bubble burst. The second time, January 2006, came just before the housing bubble burst.
What’s interesting is that since the GFC, a lot of popular theories relating to the demise of gold have been proven false. A popular theory during 2009 was that a “green shoots” recovery would cause gold prices to collapse – but they didn’t. Then there was the popular “contrarian” argument that the real threat was deflation, and that gold would sell off as a result. But gold didn’t follow the script, rising instead of falling.
Now it’s the notion that rising interest rates will kill off gold.
One of the major reasons cited by commentators and financial experts for gold’s recent sell-off has been the prevailing view that interest rates will inevitably rise as economic growth builds. Central banks (the US Fed in particular) are also concerned about the long-term implications and economic distortions caused by a low interest rate environment.
There is a widely held view that a rising interest rate environment is negative for gold. While there may be a question mark over the robustness of the overall recovery scenario, let’s assume that interest rates will rise in line with perceptions of economic growth. Why shouldn’t gold benefit from a rising interest rate environment, just as it has done in a low interest rate environment since 2008?
Let’s examine the evidence of recent history. Significantly, gold rose with interest rates during the 1970s and this is sufficient to prove that gold doesn’t always fall when interest rates rise.
The real driver of gold prices is negative real interest rates (defined by nominal interest rates minus inflation). Central bank policies of inducing negative real rates to ‘incentivize’ borrowing, expand the money supply and devalue currencies, have forced investors (especially mums and dads) into real assets like gold and silver. Debt is inherently inflationary if you have the ability to print your own currency. As the chart below highlights, it’s happened before.
In a gold bull market that has been fueled by negative real rates, conventional thinking would suggest rate increases would, at the very least, halt the rise of gold as negative real rates get closer to turning positive. However, history actually says the opposite is true. The gold bull market of the 1970s was dominated by inflation. Interest rates rose steadily to keep up with it, but real interest rates were mostly negative the entire time.
Peaks in gold prices since 1975 have usually been associated with rising real interest rates. Occasions when real interest rates fell in tandem with gold prices include the period from 1987-1990 and from 1996-2001. Even though real rates have risen slightly, they remain below their historical average and levels below 2% have still been supportive of rising gold prices.
As the chart below from Goldman Sachs demonstrates, gold prices languished from 1980 to 2000 and had declining correlations with debt levels, because GDP growth was sufficient to suppress fears about budget and deficit issues. The current economic recovery has been too weak to support a sustained rise in real rates above the 2% level that has acted an inflection point for gold prices.
With energy and food inflation deepening and soon to affect consumer price indices, interest rates may have to rise significantly in order to restore real interest rates above 2%. This is exactly what ex-Federal Reserve Chairman Volcker did during the late 1970s, when he increased interest rates above 15% in order to protect the dollar and aggressively tackle inflation.
Despite the lower gold price (or perhaps because of it), central banks outside of Western Europe and North America are continuing to increase their gold holdings. According to the latest World Gold Council statistics, central banks have been buying gold at a higher rate than last year, with a reported 240 tonnes of purchases during H1 2014 compared to 180 tonnes during H1 2013.
The above chart highlights the strong relative performance of gold compared with both the Dow Jones and NASDAQ indices since 2000.
You could remain positive on gold if you remain confident that the flow of gold from West to East will continue. There is robust price support around the US$1,200 mark, a situation that may continue for the foreseeable future.