What Rising Rates Mean For Gold Investors?

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Includes: GDXJ, GLD, RGLD
by: Anthony Fernandez

Summary

Gold investors must be cautious during this unprecedented monetary experiment.

The Fed remains committed to raising rates.

Gold is set to gain as normalization proceeds.

After the era of quantitative easing, we have persisted in this uncomfortable interlude where massive Fed activity remains on the books, but the effects are being prevented from propagating through the wider economy. The monetary base, one of the most popular topics for gold investors, remains massively expanded after three quantitative easing rounds. While many had predicted that this would bring extreme inflation rates and an incredible upswing in gold prices, neither of these predictions have come true. Instead, the Fed has paid interest on those excess reserves to ensure that the monetary base expansion does not get lent out, which would multiply the money supply and would create incredible inflation rates.

Now that the Fed has begun raising interest rates, we are entering a new era. How will gold fare in this transition to a more normal Fed balance sheet?

The Current State

Starting in 2008, the Federal Reserve increased the monetary base as the financial system was facing an unprecedented liquidity crisis. After Bernanke came in and essentially saved the banks, the balance sheet has not looked back. The Fed has mostly purchased Treasuries and mortgage-backed securities (MBS) and still holds onto these assets and rolls over the income to keep a steady base. Since 2014, there has not been a major change in the balance sheet.

While many had predicted that this would lead to price inflation and higher gold prices, neither have come to pass. The reason has been that banks have not been lending out their money.

Instead, banks have parked their reserves with the Fed and kept them there, apparently more willing to earn the meager 0.25% interest with the Fed than try to go and lend it out (which is quite telling about the state of the economy since 2008). This is an entirely modern phenomenon, as prior to 2008, there were no significant excess reserves to speak of. Banks would have their deposits and lend out as much as they could. Now, the Fed pays interest on those reserves.

Note a change between 2014 and 2016. That value fell significantly and, as suggested by others, was likely the impetus for the recent rate hike cycle. Reserves started trickling out starting around 2015, and now that the Fed has raised rates (which today basically means raising the rate that they pay on excess reserves), excess reserves are coming back. Crisis averted! Well, for now.

As rates have gone up, so has the amount that the Fed has to pay to banks to dissuade them from lending. Throughout most of this business cycle, the Fed paid banks between $4 and $8 billion per year. Today, the Fed is paying closer to $28 billion per year to banks. No big deal, right? After all, the Fed is the currency issuer and can pay whatever they need. We can stay here forever, right?

Consequences of Higher Interest Rates

Not so fast. US law stipulates that any profits that the Fed makes have to go to the treasury. A transition from $4 billion to $28 billion means that the US treasury is getting $20 billion less per year from the Fed. Guess who is making up that difference? Taxpayers. It is convoluted, but in effect, it is US taxpayers who are footing this bill to banks, the same banks who pay them no interest on their savings deposits and who collect huge interest on credit card and other debt. I wonder how most Americans would feel if they knew about this.

Beyond that, this number would simply have to increase indefinitely. Even currently, while excess reserves are not draining out of the system any longer, they are still not back to current levels. Any improvements in the real economy are going to lead to more spillage, and the Fed will have to increase payments. This situation obviously is untenable, as it only compounds the problem and will eventually lead to price inflation.

This is why the Fed is now moving toward balance sheet reduction. While this could solve the problem, it will only solve a small part of the problem. As the Fed begins unloading these securities, yields will rise and they will not receive full value for the assets that they hold. Ultimately, only a small portion of the excess reserves will be wiped away, and in the process, the Fed will start a financial crisis. And what does the Fed do in a financial crisis? They accommodate.

Future for Gold

It has been a long time coming, but the Fed is now faced with the balance sheet issue. There is no good solution and ultimately we will see higher price inflation, which will be a boon for gold. At least some portion of the excess reserves will spill out, or the Fed will be paying banks massive amount of money which will eventually also be lent out to create price inflation. The Fed is stuck. They tried to prevent the last recession, but in the end, will only produce an inflationary crisis. This is the time to hold onto real assets. This is a bad situation with no good answer and the Fed is going to take major damage.

I will not make any specific predictions about the gold price, as much of the future depends on how successfully Fed asset sales will go. Based on what happened last time they tried to sell assets, the market will overreact and they will end the program prematurely. The Fed is stuck, which is a great place for a gold investor to be.

Action to Take

I still strongly recommend physical possession of gold. There is no counterparty risk and you know what you have. Beyond that, I also recommend gold mining companies like the gold mining ETF (NYSE:GLD), gold mine financiers like Royal Gold (NYSE:RGLD). Junior gold miners will especially benefit (NYSE:GDXJ), but beware junior names come with more risk.

The future is bright for gold, and soon it will sparkle.

Disclosure: I am/we are long RGLD, GDXJ.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.