Interest Rates, Fed Policy And The Price Of Gold

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Includes: AGOL, GLD, GTU, IAU, OUNZ, PHYS, QGLDX, SGOL
by: Jeffrey Nichols

Traders and investors around the world are placing bets on whether or not the U.S. Federal Reserve, America's central bank, will soon raise short-term interest rates given the continuing ambiguity in U.S. and global economic indicators and continuing volatility in world financial markets.

Some days there seems to be a consensus in the marketplace expecting the Fed will stand pat, leaving short-term interest rates unchanged for a while longer. Other days the consensus seems to expect the Fed will sooner or later nudge rates up a tad, possibly voting to do so as early as next week's FOMC policy-setting meeting.

Voting members of the FOMC are themselves at odds on monetary policy prospects - and some may not yet know their own minds on the Committee's crucial vote to hold rates steady for a while longer or move immediately to nudge rates a tad higher, a shift in monetary policy dubbed "lift off".

Clarification of interest rate prospects could come as early as next week following the September 16th and 17th meeting of the Federal Open Market Committee, the Fed's policy-setting forum. So be ready for turbulence ahead in world stock and bond markets, U.S. dollar exchange rates, and the price of gold.

Those Fed officials, the so-called "hawks," who believe the U.S. economy has already entered a period of sustainable growth (with labor markets at or approaching full employment, with consumer price inflation still below the Fed's two percent target, and with the Wall Street bull still very much alive) are likely to vote for lift off sooner than later.

And then there are the interest rate "doves" (who believe the economy is not yet on a sustainable growth trajectory and fear Wall Street is already teetering on the brink of a major bear market) who will vote to hold short rates steady near zero where they have lingered since December 16, 2008, when the Fed unanimously cut rates to stem the spreading panic in U.S. and world financial markets.

What's all this got to do with gold? Plenty... but not in the way most gold investors, traders, and pundits have come to believe!

Ironically, several years of pro-growth monetary policies - quantitative easing and extremely low interest rates - have not fueled a continuing bull market in gold, as one might have expected, but instead supported a global bull market in stocks and bonds, a bull market that prompted many investors to lessen their gold holdings in favor of ordinary stocks and bonds where anticipated returns exceeded the benefits of holding gold.

Former Treasury Secretary and presidential advisor Lawrence Summers has in recent days warned that if some of the global fears surrounding China and a global slowdown ultimately prove warranted, "a tip of the Fed toward tightening risks catastrophic error."

There seems to be a global market consensus that whatever the Fed chooses to do - raise rates or not - the U.S. economy and financial markets are in for difficult times ahead.

We agree that even a small bump up in interest rates could ignite a flight of funds from ordinary stocks and bonds, with many investors rushing into gold, perceived as the ultimate "safe haven" and insurance policy against a financial disaster.

Many investors continue to believe an interest rate hike, even a tiny increase, will draw still more money out of non-interest-bearing gold, as investors seek higher returns on interest-bearing financial assets.

The popular belief that rising interest rates must weigh down gold is not supported by the historical evidence. In fact, if history is a guide, we should expect rising gold prices to accompany rising interest rates in the next few years - much like the 1970s which saw gold rise from under $35 an ounce to over $850 an ounce in January 1980.

Again, in contrast to conventional wisdom, gold suffered through an extended bear market in the 1980s and 1990s, a period of generally falling interest rates that "should" have supported rising gold prices.

This time around, higher interest rates now or in the months to come, will more likely undermine the aging bull market on Wall Street - making stocks and bonds less attractive to investors - thereby reigniting the bull market in gold.

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