A common misconception in markets about the price of gold is that rising interest rates for a currency will always drive the price of gold down against it. I shall come to market relationships in a moment, but first we must look at the economic relationship between gold and currency.
The primary driver is changes between the relative quantities of gold and currency, with an overlay of changes in confidence for the currency itself. This quantity relationship is simple to understand and needs little elaboration; but it does not mean that a doubling in the quantity of paper money automatically leads to a doubling of the price of gold. The reason is the purchasing power of a currency can and does vary independently from changes in its quantity. Gold, however, is seen by the majority of the world's population as a better store of value than local currency, so its appeal is global instead of being tied to a single currency's jurisdiction.
This means that over time the most important relationship between gold and currency cannot be interest rates. However, assuming a period of general stability in a major currency such as the US dollar, interest rates then do come into play. We must take account of traders' opinions, which are normally confined to dealings in the paper markets. There are two different situations to consider: when changes in interest rate policy discount tighter monetary conditions, and when monetary policy reacts to events and therefore do not discount them.
If a central bank tightens monetary policy to fully discount expectations of rising interest rates, then traders will sell gold, on the basis that a central bank is leaning towards a hard money policy, lessening the attractions of gold as an inflation hedge. They will also point out that the cost of foregoing higher interest rates for currency deposits makes ownership of gold less attractive. These were the conditions introduced by the Fed and the Bank of England in the early 1980s, which contributed to the fall in the gold price for the rest of the decade.
The second relationship, which helped drive the gold price in the 1970s, is the opposite. In this case the central bank is reluctant to raise interest rates until forced to do so. This bias is towards a weak monetary policy, which is beneficial for gold, and in this case rising interest rates do not lessen its attractions.
Today the market can best be described as confused. Prospects for economic growth and price inflation are far from clear to the market consensus, so talk of tapering by the Fed is seen as injecting a deflationary bias. For this reason, when bond yields rise, gold weakens.
Traders in paper markets are only interested in short-term relationships, and therefore pay little or no attention to long-term fundamentals. If we consider the relative increases in the quantity of gold and a fiat currency such as the dollar, gold today is demonstrably undervalued compared with where it was before the Lehman crisis.
This is confirmed by physical metal being driven out of market circulation. Sooner or later, those traders ignorant of Gresham's Law and believing that interest rates are the sole determinant of the direction of prices will get an interesting wake-up call.
