Gold in Fed-Rate-Hike Cycles

by Adam Hamilton, Zeal, LLC The epicenter of gold’s intractable weakness over the past couple years has been the Federal Reserve’s upcoming rate-hike cycle. Everyone assumes higher interest rates will devastate zero-yielding gold, leaving it far less attractive. This premise led investors to avoid gold like the plague, and speculators to short sell it at wild record extremes. But provocatively, history proves gold thrives in Fed-rate-hike cycles. It’s easy to understand how the Fed’s first rate-hike cycle in over 9 years has cast a pall over traders’ gold outlook. While gold’s unique attributes make it exceptionally valuable for portfolio diversification, it generates no cash flows. Gold will never pay dividends or interest, which makes it a sterile investment. Presumably demand for yield-less assets will wane as rate hikes naturally force yields on bonds higher. While this bearish gold thesis sounds perfectly logical, its core assumption is fatally flawed. While gold has never offered a yield, investors all over the world have still flocked to it all throughout history. They certainly weren’t looking for a yield play, and bought gold to take advantage of its formidable strengths on other fronts. If yield had ever been this metal’s dominant attribute, gold would indeed be essentially worthless. While gold was infinitely outgunned on yields by literally everything that pays one, it still blasted 638% higher in the decade ending in August 2011. These returns were vastly superior to the dividend-heavy S&P 500, which slid 1.9% over that same 10.4-year span. While yielding absolutely nothing, gold still skyrocketed 2332% higher in the decade ending in January 1980! Bond yields were crazy-high then too. Gold has never been a yield play, and never will be. The widespread antipathy towards this leading alternative investment today on the idea that rising rates will slaughter it is simply a flimsy rationalization of popular bearishness. Consider how silly this yield-trumps-all notion would be in the stock markets, where plenty of the hottest and most-adored stocks like Amazon and Netflix have never paid dividends. Dividend-less stocks are sterile investments just like gold, yet Wall Street fawns on them. Just like gold, their prices are determined by the intersection of trader supply and demand that has nothing to do with their zero-yielding nature. Have you ever heard anyone argue that higher prevailing interest rates are going to devastate stocks that don’t pay dividends? Of course not, and that notion is just as tenuous applied to gold. So rather than blindly accepting today’s groupthink belief that gold is doomed in the Fed’s upcoming rate-hike cycle, why not check the historical record? While this uber-dovish Fed hasn’t raised interest rates in many years, there have still been plenty of Fed-rate-hike cycles in modern history. So how has zero-yielding gold performed during these past central-bank tightenings? Are rate hikes really a threat to gold? To find out, I downloaded nearly a half-century of daily Federal Funds Rate data directly from the Fed itself. This FFR is the primary interest rate the Fed directly controls, what it sets its policy target for when it hikes or cuts rates. The federal-funds market is where banks lend and borrow cash deposits on an overnight basis that they hold at the Federal Reserve. Most other interest rates key off the Fed’s FFR. In a mind-numbing exercise of tedium, I looked at every decision by the Fed’s Federal Open Market Committee that sets the federal-funds-rate target since 1971. And there were a lot of them, the FOMC changed its federal-funds-rate target 251 times in the 46 years since. I found that high number pretty surprising. The FOMC holds 8 policy meetings per year, equating to around 368 over that entire span. That implies the FOMC either hiked or cut the FFR at over 2/3rds of its meetings, which seems way too high. And it probably is, since the FOMC sometimes chooses to change rates between meetings when volatile market conditions sufficiently frighten its members. But there has been an abundance of Fed rate hikes over the past half-century, a large sample size to see how zero-yielding gold has fared in their midst. Since investors and speculators today are very worried about how gold will perform in a sustained Federal Reserve rate-hike cycle, I ignored isolated FFR hikes surrounded by cuts. Since 1971 the Fed has made 6 lone rate hikes bracketed by cuts. And there were 6 more episodes where the FFR was raised two times back-to-back but was then reduced again. One or two isolated hikes certainly don’t make a cycle. I decided to generously define a Fed-rate-hike cycle as 3 or more consecutive increases in the federal-funds rate with no decreases. These rate-hike cycles start at the Fed’s first rate hike, and end at the Fed’s last rate hike before it starts cutting rates again. By this 3-or-more definition, the Federal Reserve has executed 11 rate-hike cycles since 1971. Gold’s performance in these is critical for its outlook today. While this red daily federal-funds-rate data is directly from the Fed itself, it looks a lot more volatile than most would expect. This is because the FFR is technically a free-market interest rate determined by the federal-funds supply and demand from commercial banks. The FOMC doesn’t actually directly set its FFR, instead it sets a target level which it then attempts to achieve through its own federal-funds buying and selling. For each Fed-rate-hike cycle, 4 key metrics are noted. Each cycle’s total federal-funds-rate increase in basis-point terms is shown in red, followed by the number of separate hikes it took the Fed to complete. That’s followed by how long each rate-hike cycle took in months in white. And last but not least is gold’s price reaction over the exact spans of the Fed’s rate-hike cycles in blue. This really defies prevailing consensus. Continue Reading>>>

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