What will happen to the gold price when interest rates rise?

September 22, 2015 11:09 am

What will happen to the gold price when the interest rates rise?

It is a universal truth that when the US dollar strengthens the gold price weakens. They are at a constant antithesis and act as a natural balance or counterweight to the other. If we look at the facts and price fluctuation, when the dollar index declined in 2007, the gold price increased. Again the dollar’s significant drop from May 2010 to until mid-way in 2011 was balanced considerably by gold’s continued meteoric rise. It is no coincidence that the dollar’s historic lows in mid 2011 equated to gold’s record highs.

Having said that, is it right to solely assume that gold, along with other asset classes, will depreciate given the dollar’s continuing strength?

Here are 2 scenarios about the interest rates rise:

*Some rational imagination will be required – also please note: these are scenarios only and the opinion of this commentator only – always seek independent financial advice*

Interest rates rise

Interest rates rise: what will happen next?

Scenario 1

So the FED have raised interest rates. They’ve stated that from next month they will be raising the interest rates from 0% to a staggering 0.25%. The interest rates rise puts downward pressure on Gold and other asset classes as is the typical pattern. Naturally investors in the Credit and Equities markets, who have been well informed of the impending rates rise have completely overreacted. The equities markets for the short term receive the news as a confirmation that the economy is in true recovery and the equities markets are buoyed. The credit market (also known as bond market) reacts very differently. The incremental rates rise sends bond yields higher which in-return mean the bond prices fall. The credit market contains not only safe credit classes such as gilts but also riskier company bonds. The longer and supposed safer bonds such as gilts, are worst hit whilst the riskier high-yield also known as junk bonds, are less effected. The consequences are the following: investors who invested in the safer bonds as a form of hedge against riskier asset classes in their portfolio, are caught in the headlights. They lose out on their bonds and now have the decision of sticking with a depreciating asset or to jump ship to a higher risk bond.

In the long term, the equities market will be forced into correction later on down the line. The increase in interests rates that rattled the credit market at the beginning have eased. As the FED have increased the interest rates, more and more equities investors have found themselves drawn to the attractive yields being offered by the credit markets. The shift from Equities to Credit is more and more aggressive and the over-pricing of the Equities market fuelled by optimism begins to look like folly and the correction begins.

For gold in the long-term it does not look at all bad. The depreciation gold had in the beginning has slowed to a plateau. The effects of an increased dollar is now being felt by all and sundry. The 60 plus countries that have pegged their currency to the dollar have felt the real effects of an increased dollar. Likewise everyone from the banks to the common man have felt the effects of the interest rates. Businesses and customers alike have higher operating costs as mortgages, loans and credit repayments are now higher. Gold conversely has been waiting in the doldrums looking rather hawkish and the price looks very attractive for the fleeing investors out of the stock markets.

Scenario 2

So the FED have raised interest rates. They’ve stated that from next month they will be raising the interest rates from 0% to a staggering 0.25%. The first reaction is felt most severely in the equities markets. Although they have known about the impending rates rise, they are still taken aback and investor confidence is still fragile. The equities markets begin to correct as the realisation occurs that the joy-filled train ride that has pushed the markets up in the first place, is actually a never ending roller-coaster being operated by a sadistic maniac. The increase in interest rates rocks pretty much everything. The emerging markets, the property market, equities: they are all going to take a hit as the interest rates rise increases costs in all sectors. The increase in interest rates slows lending in the banking sector and tightens credit for consumers and business. The Credit Market on the other hand sees the bond prices fall as the yields increase and gets an uplift from the panic in the equities markets and money soon floods in. Many investors will be caught in no man’s land and those of us not lucky enough to know a dealer in the bond market will watch our investments across the board depreciate.

For Gold, the price pre-interest rates rise has had its correction. As the dollar increased after late 2011, the gold price courteously fell from the highs of $1896.5 to a more modest $1080.05 dollars and has settled. With the increasing dollar price the usual pattern of a falling gold price does not occur. Much like the moderate increases the dollar felt in late 2009 to early 2010, the gold price shakes off the downward pressure and rises. It pays little to no attention to the dollar price. As is gold’s mercurial aspect as an asset class, it reviews a whole spectrum of financial instruments not just the dollar index. It sees the big correction in the equities markets and the lull that will occur in the other markets such as property and thus gold rises. Investors begin to worry that the cycle has begun again and wily investors begin to hedge using gold.

Verdict:- Interest rates rise is inevitable. It will happen eventually and the drama that will be played out we will have to sit and wait for. Gold’s place as world currency and hedge will become even more relevant as the years continue. In either scenario gold’s place is always relevant and always the quiet asset class artfully waiting until it is needed again. The final and third scenario that could well happen is that the interest rates make very to little effect on markets and gold. The reality is the 0.25% increase is such a modicum that the likelihood of negligible change is quite likely. After all, Yellen and her committee members are not trying to capsize the boat they’ve dovishly steered for so long.

Article by Michael Cooper

email:-Michael Cooper


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