Gold investors can stop worrying. Despite recent chatter, interest rate tinkering at the Federal Reserve is not driving the price of gold.
That said, it’s easy to understand the confusion…
The price of gold dropped to a three-week low after the Fed released the minutes of its April meeting on May 18, suggesting it may lift interest rates in June. If U.S. employment figures are strong and inflation moves closer to the Fed’s 2 percent target, the U.S. central bank may raise the federal funds rate (the rate it charges to lend money to other U.S. banks). As you likely know, the Fed raised its benchmark rate last December for the first time since 2006.
On Friday, Federal Reserve Chairwoman Janet Yellen hinted again at higher rates, saying a rate hike would likely be appropriate “in the coming months.” If it is a similar hike to December’s, that means it will rise another quarter of a percentage point leaving the rate in a range of 0.5 – 0.75 percent – still very low.
Gold is now down 6.3 percent from the 2016 high it hit on May 2. Even the so-called “smart money” is pulling back a bit from gold in anticipation of higher interest rates. Earlier this week, Bloomberg reported that hedge funds have cut their gold holdings since January.
However, the truth is, a possible June rate hike is not the real reason gold prices have dropped. Gold dropped because higher rates would strengthen the U.S. dollar.
You see, when the Fed lifts interest rates, investors buy more U.S. dollars – because those dollars (after an interest rate hike) pay more interest. Gold, on the other hand, does not pay any interest. So, when investors can earn more holding other low-risk assets like the U.S. dollar, gold prices suffer. But that’s about the only way the Federal Reserve can influence gold prices.
Historically, gold prices move independently of the Fed’s actions
The chart below shows the federal funds rate and gold prices since 1976. There were seven periods of significant interest rate hikes over this 40-year stretch. For three of those periods, gold prices dropped for roughly the two years after the rate hikes began. During one set of hikes, gold prices stayed relatively flat. And, during the three other periods, gold prices increased along with interest rates.
Note that, in the late 1970s, when gold prices climbed with interest rates, the climb coincided with an ongoing gold bull market. Gold prices rose 118 percent in the two years after the Fed started that series of rate hikes.
Something similar happened after the Fed began lifting rates in 2004. One year later, gold prices were up 11 percent. Two years later, they were up 57 percent.
But, overall, gold does not necessarily go one way or another when the Fed raises rates.
You can see this non-pattern in the neutral correlation between the federal funds rate and the price of gold. Correlation measures the relationship between two or more assets, on a scale of positive 1 to negative 1. When two assets have a positive correlation (approaching 1), they tend to move in the same direction at about the same time. When they have a negative correlation (approaching -1), they tend to move in opposite directions.
A strong positive or negative correlation doesn’t mean one asset causes the other to move. It just means one asset usually goes up or down when the other goes up or down. A correlation of, or close to, zero means two assets move independently.
As you’ll see in the following chart, the correlation between gold prices and the federal funds rate is weak. While it’s increased slightly over the past five years, it usually hovers near zero. (The federal funds rate is not an asset, but we can still measure its correlation to the price of assets like gold).
The strength or weakness of the U.S. dollar – measured here by the U.S. dollar index, which tracks the dollar against other major currencies – is a strong indicator of gold’s next move.
As you can see in the chart below, gold prices and the U.S. dollar have a strong negative correlation. Historically, it lingers near -0.4. That means that when the value of the dollar goes up, gold prices tend to go down, and vice versa.
This strong negative correlation is apparent when you look at their long-term price histories. The next chart shows the U.S. dollar and gold prices over the past 40 years. Notice how gold prices (in red) tend to go up when the value of the U.S. dollar (in black) goes down.
When gold prices climbed in the late 1970s, the U.S. dollar was struggling compared to other major currencies. Then, as the dollar climbed 88 percent higher from June 1980 to February 1985, gold prices fell 56 percent.
When the U.S. dollar started falling in 2002, gold began a massive bull run. It climbed 55 percent over the next 35 months.
And, as the U.S. dollar climbed 37 percent from April 2011 to November 2015, gold prices were weak, falling 32 percent.
Put simply, if you want to know what gold will do next, forget about the Fed and look at the U.S. dollar.
Regardless of the short-term changes in the price of gold, it’s good to own some anyway. It is one of the best hedges against stock market declines and is viewed as an alternative currency that holds its value.
To get exposure to gold, try the SPDR Gold Shares ETF (Singapore; code: O87), or the Value Gold ETF (Hong Kong; code 3081). Both ETFs own actual physical gold and allow investors to track gold prices. You can also buy the SPDR Gold Trust ETF on the New York Stock Exchange (ticker: GLD).