Correlation Between Gold and Interest Rates?

By now it’s a familiar story—Gold prices don’t like interest rate hikes. 

Last Wednesday, the minutes of an April Federal Reserve Policy meeting were released, and it became clear that the feds are seriously considering tightening the economy next month. 

Gold prices reacted fast by losing 1.7 percent, landing at their lowest in 3 weeks.

It Has Almost Become Received Wisdom at This Point That Gold Prices Have an Inverse Relationship to Interest Rates

• Claude Erb on MarketWatch says it, claiming that the r-squared for an inverse gold-to-interest-rate model is a staggering 0.78.
• CNBC says it, pointing out a historical trend for gold prices to go down when interest rates rise.
• Even the International Business Times cites the inverse gold-price-to-interest-rate phenomenon as a long-held view amongst financiers.

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However, Investors Are Superstitious—Believing In A Lot Of Things, Not All Of Them True

Is the 1.7% drop a short-term effect? 

Do higher interest rates really have a long-lasting, negative effect on gold?

Investopedia Claims That Higher Interest Rates May Not, in Fact, Depress Gold

Investopedia points out that there is no statistical proof of a correlation between interest rates and the price of gold. 

It acknowledges that bonds garner more attention as interest rates rise and may take investors away from gold. 

However, it states that when an analysis is done of trends in gold prices and interest rates from 1970 to 2015, an odd truth is revealed:

There is no meaningful correlation. To be exact, the correlation is 28%—which is not literally nothing, but is also not statistically significant.

The Gold Boom of the 1970s

There was a very stout bull market in gold back in the 70s during which gold prices and interest rates rose at the same time. 

Short-term interest rates began the decade at 3.5% while gold began the decade at $50 an ounce. 

By the end of the decade, interest was at an enormous 16%, and gold was at an even more enormous $850 an ounce.

If there were, in fact, a reliable, long-term inverse correlation between gold and interest rates, how on earth did such a boom happen, and how did it happen with gold and interest rates in such close tandem? 

The peaks and valleys along that decade were not alternating between gold prices and interest rates. 

Instead, gold went up with interest rates.

But Wait, There’s More

The Australian bank Macquarie believes that gold may not, in fact, suffer that much from the interest rate hike. 

They note that the Feds have hiked interest rates 31 times in the last 22 years and that overall gold has gained just a little more than it has lost when it comes to price. 

One notable result they cite, though it was far from typical, is gold gaining 3% in price during a major rate hike in 2006.

So if Not Gold, What Do Higher Interest Rates Impact?

• Stocks: Investors flock to bonds with their new, higher yields.
• Mortgage interest rates:  Banks have to pay more to borrow from the federal government, and the cost gets passed on to the consumer.
• Credit Cards interest rates:  It’s the same principle that mortgage rates work on.
• Business spending slows: Again, it costs more to borrow from banks, so businesses simply don’t if they don’t have to.

The Stock Market May Suffer More Than Gold from the Projected Interest Hikes

Not only do bonds attract more investors with their suddenly higher yields, but company costs often go up, leading to lower profit margins and devalued stocks. 

Investors know this and will be hesitant to buy stocks which may lose worth when the dreaded interest rate hikes occur.

Ironically, This May Help Gold Rather Than Hurt it

Gold is considered a viable alternative investment when stocks are risky. 

Investors who lose confidence in the stock market may, in fact, turn to gold, raising demand and thus prices. 

When the S&P 500 dropped more than 40% in the seventies, gold prices proceeded to rise by at least 150%.

Why, Then, the Recent Drop?

It does not seem impossible that the received wisdom of gold and interest rates being inversely related is becoming a self-fulfilling prophecy. 

At least in the short term, investors hear about a rate hike, remember that they have been told that rate hikes are bad for gold, and sell quickly before their investment can depreciate. 

Meanwhile, demand (and prices) go down, because investors don’t want to buy into a commodity that is going to drop in price.

Simply put, even though historical evidence is not there, people are superstitious about their gold investment and rate hikes.

Conclusion

It is to be hoped that investors educate themselves more about the minimal correlation between gold prices and rate hikes. 

Given the fact that it is the stock market that suffers more from hikes, and gold is a popular alternative to stock, those who do educate themselves may, in fact, have the opportunity to make a killing on gold in the long run.