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Gold?s sharp
early-year surge has fizzled in recent weeks as investment demand
faded. The primary reason is the universal belief that the Fed?s
upcoming rate hikes are very bearish for gold. Higher rates will
make zero-yielding gold relatively less attractive, argues this
popular thesis. But history proves just the opposite. Gold
actually thrives in rising- and higher-rate environments, so rate
hikes are nothing to fear.
This notion
definitely seems counterintuitive today. When the Fed finally
begins letting interest rates start to normalize after actively
suppressing them for years on end, yields on bonds and cash in the
form of money-market funds will rise. That will make these asset
classes more appealing to investors. So they will migrate out of
gold, which yields nothing, into the new higher-yielding bonds and
money-market funds.
This logic is
simple, which is why the great majority of investors and speculators
today believe that gold is going to face relentless selling as rates
rise. But rather than accepting this conventional ?wisdom? at face
value, why not see what?s happened in the past? Did the earlier
periods of rising and higher rates suck vast amounts of capital out
of gold, deflating its price? If not, then this popular thesis is
dead wrong.
It?s funny how
ideas take root and flourish in the financial markets. Traders are
highly emotional, with most of their trading decisions based on
greed and fear. They also have an overwhelming status-quo bias,
expecting current market conditions to persist indefinitely. Thus
any rationalization of why stock markets will rally on balance
forever while gold fades into oblivion are quickly seized on and
trumpeted as truth.
With traders?
collective greed and fear constantly overriding their rationality,
popular fallacies always exist. They include widespread beliefs
today that market history proves are ridiculous. Such as the ideas
that stock markets can rally perpetually without corrections or
bears, that
stock-market valuations don?t matter, and that central banks can
successfully manipulate prices forever. History makes a mockery of
these!
Yet traders
believe what they want to, whatever seems to bolster their views
that existing trends have turned permanent in some new era. But the
past record is crystal-clear, financial markets are forever
cyclical. Asset classes rise as they grow popular, but then
inevitably subsequently fall as they drift out of favor again. Gold
is no exception. Gold can?t drift lower forever any more than stock
markets can rally forever.
So instead of just
blindly accepting today?s belief that the Fed?s rate hikes are
bearish for gold, why not check the historical record? This first
chart includes over 45 years of daily gold-price and
interest-rate data. For interest rates I used the yields on
benchmark 1-year Treasury bills and 10-year Treasury notes to
represent both the short and long ends of the yield curve. Are
rising and higher rates really bearish for gold?
The simple answer
is absolutely not. Gold?s mighty secular bull of the 1970s, which
greatly dwarfed the 2000s one, happened during a time of high and
rising interest rates! And then gold?s subsequent multi-decade
secular bear in the 1980s and 1990s unfolded during a long span of
interest rates relentlessly falling on balance. Gold rallying with
rising rates and slumping with falling rates? That?s not in the
script.
And over this
chart?s entire nearly-half-century span, gold and interest rates
were actually not highly correlated at all. While gold indeed had
the negative correlation with rates that many today expect, it was
actually very weak. Gold?s correlation r-squares with 1-year and
10-year Treasury yields ran merely 29% and 28% respectively between
1970 and 2015. For all intents and purposes, this is essentially
uncorrelated.
Mathematically,
only well under a third of gold?s daily price action was
directly explainable by short- or long-term interest rates. This
wouldn?t be the case if higher rates made gold far less attractive
to investors and vice versa, so today?s popular thesis about gold
and rates is simply false historically. Actually well over
two-thirds of the gold-price action in our lifetimes had nothing to
do with the changing interest rates!
Like all other
prices, gold?s are driven by global supply and demand. And since it
takes over a decade to advance a deposit into an operating mine,
gold?s supply changes very slowly. All the real fundamental action
in the yellow metal comes on the demand side. And the big wildcard
on that half of the equation comes from investment demand, which can
fluctuate massively at the margin. It drives all gold?s big moves.
So interest rates
could only affect gold through investment demand. Today?s traders
believe rising and higher rates retard gold investment demand as
investors shift capital to higher-yielding bonds. But they have a
monumental historical problem in the form of the biggest secular
gold bull of our lifetimes. Back in the 1970s when gold skyrocketed
over 24x higher in nominal terms, it actually moved
with interest rates!
Way back in March
1971, short rates as represented by 1-year T-Bill yields bottomed at
3.5%. And by October 1979, they would nearly quadruple to
13.6%! Now no one today even thinks the Fed hiking the Federal
Funds Rate it directly controls to double-digit ranges is even
possible. So there is truly no more extreme example than the 1970s
to reveal how rising and higher rates affect gold investment demand.
And obviously gold
bucked today?s consensus and soared right alongside interest rates!
It actually had very high positive correlations with 1-year
and 10-year Treasury yields, enough to generate very strong
r-squares of 64% and 83% respectively. So from two-thirds to over
four-fifths of gold?s bullish upside price action between 1970 and
1980 was directly mathematically explainable by the rising
interest rates.
Gold was actually
strongest when the short-term interest rates utterly dominated by
the Fed Funds Rate were rising the fastest. Note gold?s giant
spikes in 1973 and 1974 as rates soared in direct response to Fed
rate hikes. And then gold actually slumped in 1975 and 1976 as
interest rates fell, which again flies in the face of what traders
expect today. Then it soared again in 1978 and 1979 as rates
skyrocketed.
So in the biggest
secular gold bull of our lifetimes by far, rising and higher rates
were as far from being bearish for gold as they can get. Just the
opposite was true, the faster the rate hikes and the higher the
rates went, the more investment demand for gold soared! This
relationship only seems counterintuitive today because traders?
status-quo bias has temporarily blinded them to normal cyclical
market behavior.
Rising and higher
interest rates are actually bullish for gold for one simple reason.
And that is they are actually very bearish for stocks and bonds.
Gold is an alternative asset that shines the brightest when the
conventional asset classes are suffering. And nothing pummels stock
and bond markets like rising interest rates. That is the sole
reason the Fed has been so darned slow in normalizing interest
rates!
Rising and higher
rates hit the stock markets in a variety of ways. They make bond
investing relatively more attractive for stock capital. In periods
of low interest rates, bond investors are often forced into the
stock markets to chase yields. But they never like being there, as
stocks paying healthy dividends are always at risk of seeing major
price declines. There is essentially zero principal risk in bonds
held to maturity.
So as rates rise,
the bond investors grudgingly holding stocks exit to migrate back
into their favored asset class. Since the pools of bond-market
capital are so vast, this selling pushes the stock markets lower.
Rising and higher rates also make stock markets look more
overvalued in several ways. When bond yields are higher,
investors are far less willing to pay high prices in
price-to-earnings-ratio terms for stocks.
So the lower
demand won?t support overvalued stock markets, and they sell off.
The higher rates also directly hit corporate profits, which further
erode valuations. Companies? debt-servicing expenses rise with
rates, reducing earnings. And their customers also face the same
higher borrowing costs, so they buy less which dampens corporate
sales. And lower sales also naturally lead to lower profits of
course.
When stock markets
start flagging significantly, which rate hikes usually ensure,
investors start flocking to alternative investments led by
gold that thrive when general stocks are weak. The reason that gold
rocketed 186% higher in 1973 and 1974 despite 1-year Treasury yields
climbing from 5.7% to 7.4% with far-higher 9.2% and 10.0% rate
spikes within this span was the S&P 500 plummeted by 42% during it!
Rising and higher
rates crushed stock markets, so gold investment demand
exploded as a safe haven that wouldn?t get sucked into the stock
markets? downside maelstrom. And conversely when the S&P 500
rebounded out of its 1973-1974 cyclical bear to soar 57% higher in
1975 and 1976, gold plunged 28% despite short rates falling from
7.4% to 4.9%. The stock-market fortunes were the key to gold
in the 1970s.
And they still are
today. The only reason gold plummeted in 2013 on epic extreme
GLD-gold-ETF
and gold-futures
selling was because the Fed?s radically-unprecedented open-ended
third quantitative-easing campaign and associated jawboning
catapulted the
general stock markets far higher. When conventional investments
are surging, investment demand for alternatives naturally fades away
to nothing.
The Fed?s
artificial prolonging of this latest cyclical stock bull with
extreme money printing is the sole reason gold fell so deeply
out of favor in the past couple of years. But these lofty
Fed-goosed stock markets are long overdue to roll over into the next
cyclical bear, and when that happens gold will shine as investors
again seek out alternative investments. The Fed?s rate hikes will
accelerate this process.
The benchmark S&P
500 has soared an astounding 209% higher in 5.8 years as of late
December, far beyond the average ranges of normal cyclical bulls.
Its elite component stocks were trading at a
nearly-bubble-level average trailing-twelve-month
price-to-earnings ratio of 25.1x at the end of last month!
And it?s been a staggering 3.4 years since the last stock-market
correction exceeding 10%. A major selloff is inevitable.
And whenever it
happens, gold will catch a huge bid regardless of what interest
rates are doing. Again the only reason the Fed has kept its
risky and asinine zero-interest-rate policy in place since December
2008 despite the soaring stock markets and improving jobs picture is
because it is rightfully terrified of what rate hikes will do to
these wildly-overextended stock markets. But it will soon have to
act regardless.
Fleeing into bonds
isn?t a great option for stock-market capital either, as rising and
higher rates are even more devastating for bond markets. Bonds are
debt contracts with yields fixed at issuance, yet those
yields have to trade at current prevailing rates. So as rates rise,
bonds are sold until their prices fall low enough for their
fixed payments to equal current yields. This means big principal
losses for investors.
Long-term
investors can hold bonds to maturity to avoid the inevitable
mid-term principal losses. But this is a tough bet to make, since
new bonds are always coming out in rising-rate periods with higher
yields. This makes bond investing an utter minefield when the Fed
is hiking rates, an unforgiving realm that makes capital
appreciation very difficult for even the best traders. Gold can be
much more appealing.
If investment
capital is flowing into gold due to rate hikes? serious adverse
impact on stocks and bonds, investors in both are attracted to its
high returns. When gold is rallying while both stock and bond
prices are falling, the gold investment demand grows dramatically
and feeds on itself. So contrary to popular ?wisdom? today, rising-
and higher-rate environments are super-bullish for gold investment
demand.
This final chart
looks at gold and the benchmark Treasury short and long rates during
the last secular gold bull of the 2000s. While neither gold?s bull
run nor the interest-rate cycles were anywhere near as extreme as in
the 1970s, they still prove how wrong today?s universal belief is
that Fed rate hikes are bad news for gold. Gold actually soared
during the Fed?s last rate-hike cycle, and thrived in much
higher rates.
It is true that
interest rates meandered lower on balance during gold?s last secular
bull. As gold blasted 7.4x higher between April 2001 and August
2011, 1-year and 10-year Treasury yields plummeted by 98% and 58%
respectively. But it wasn?t the Fed-imposed artificially-low
interest rates that drove this latest gold bull. Gold peaked fairly
early in the Fed?s ZIRP campaign, and well before 10-year yields
bottomed.
And that entire
massive gold bull happened in a far-higher rate environment
than today?s. Over its long 10.4-year span, 1-year and 10-year
Treasury yields averaged 2.2% and 4.1%. These are way higher than
today?s prevailing yields, 10.2x and 2.0x respectively. If gold
enjoyed such incredible investment demand at these far-higher yields
than today?s, then why are Fed rate hikes back up to these same
levels bearish?
Obviously they?re
not. But today?s emotional investors and speculators want to
irrationally believe the Fed?s conjured fiction of stock markets
rallying forever. So they always look to rationalize their
status-quo bias, to latch on to any thesis, no matter how flimsy, if
it supports their worldview. And that is today?s absurd belief that
financial markets are no longer cyclical, that stocks rally forever
while gold slumps forever.
Why succumb to
this dangerous groupthink instead of simply consulting the
historical record? If Fed rate hikes are bearish for gold as
everyone assumes these days, then it must have been pounded in the
last major rate-hike cycle. That happened between June 2004 and
June 2006, a two-year span where the Fed more than quintupled
its Federal Funds Rate from 1.00% to 5.25%. Did gold utterly
collapse?
Not so you?d
notice. Over the exact span of that last major Fed-rate-hike
campaign, from FOMC day to FOMC day, gold blasted 49.5% higher! Its
young secular bull actually accelerated dramatically while
the Fed was aggressively raising rates. Since rising and higher
rates make stocks and bonds look a lot less attractive and a lot
more overpriced, alternative investments led by gold return to
favor. Don?t forget that.
Today?s universal
belief that the Fed?s next rate-hike cycle is bearish for gold is
total garbage. It just blows my mind that anyone actually believes
it. How can anyone be so foolishly susceptible to herd groupthink
that they can?t spend a couple hours studying gold?s actual
reactions during past rising- and higher-rate environments? If rate
hikes are bearish for gold, then it would be readily apparent in
historical data.
Gold?s latest woes
were exacerbated by last Friday?s big upside surprise on the US
monthly jobs report. It ignited heavy gold selling that ultimately
pounded the metal down 2.4% that day alone. Why? Because the
better-than-expected jobs read led gold-futures traders to think the
Fed?s rate hikes are going to start sooner rather than later. And
these naive speculators chose to believe rationalizations instead of
history.
Just like in the
past, the inevitable upcoming Fed rate-hike cycle is going to be
super-bullish for gold. The rising and higher rates are going to
hammer these lofty, overvalued, and overextended stock and bond
markets. And that will lead prudent investors to seek alternatives,
places to park their capital that move inversely to stocks.
There?s zero doubt gold investment demand will surge during the
coming rate hikes.
And since gold
investment demand on the margin determines gold prices, the yellow
metal will soar too. You can ride it higher in physical gold coins
or the flagship
GLD gold ETF. And if you want to leverage gold?s coming gains
as the Fed pricks its own stock-market bubble, the
beaten-down gold
stocks will greatly outperform gold to the upside. Only
brave contrarians fighting the crowd now will maximize their gains.
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popular falsehoods plaguing the markets today like this
gold-and-rate-hikes one, it?s never been more important to cultivate
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The bottom line is
contrary to the popular belief today, rising- and higher-rate
environments are actually very bullish for gold. Rather than making
a zero-yielding asset look relatively less attractive, rate hikes
serve to hammer conventional stock and bond markets. This leads
investors to seek alternatives that rally in times of general-stock
weakness. And gold has always been the leading safe-haven
investment.
This was certainly
true during the epic rate hikes of the 1970s, where gold soared when
the Fed was the most aggressive with its extreme rate hikes. And it
was also true during the Fed?s last major rate-hike cycle of the
mid-2000s, when short rates more than quintupled yet gold still
surged. And gold is set to defy today?s silly universal groupthink
delusion and power higher again in the coming Fed rate hikes.
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