Gold Prices And The Fed Funds Rate

Includes: GLD
by: Gregory Hines
With the bull market in gold surpassing 10 years, many investors have wondered how an asset with no intrinsic value can be in abubblefor so long. Some have asserted that gold is doomed to collapse because it isnt a dividend-generating asset like a stock or bond. While I agree that gold cannot compete with financial assets such as stocks or bonds, the bull market in gold will persist primarily for other reasons. While investors may pile into gold during times of uncertainty, the fundamental reason gold has risen and will continue to rise is monetary. The fact remains that gold has been money for centuries and is a better alternative than fiat currencies. With all central banks in a race to debase in order to buoy exports to support struggling economies, gold will continue to rise.

In the past few years, rates have been at historic lows and investors have struggled to earn a positive return. I'll attempt to elaborate on the connection between low interest rates and higher gold prices.

The Fed funds rate data and gold price data were gathered from the Federal Reserve Board and the World Gold Council, respectively. I have used 1979 as a base year, calculating changes as basic holding period returns. In 1979, the initial Fed funds rate was 10.07 and the initial price of gold was 227.30. Thus, 100% on the x-axis would represent a doubling of the gold price. The Fed fund rate was chosen as it is the dominant tool used by the Federal Reserve to control interests. It also has the shortest term of all interest rates. In this respect, it can be seen as the rate the anchors the yield curve and effects all longer term rates.

This graph uses 2000 as a base year with an initial Fed funds rate of 6.24 and an initial gold price of 274.5.

The results indicate a relationship between higher gold prices and lower interest rates. Both charts indicate that a rise in interest rates preceded the fall in gold prices during 1979-82. During the current bull market, low interest rates are related to the rising price in gold. If gold is money, this relationship could be interpreted for investors seeking a form of protection during low nominal interest rate and possibly negative real interest rates. With Ben Bernanke promising to keep rates low until 2013, the bull market in gold doesn’t look to end any time soon.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.