The Effect of Fed Funds Rate Hikes on Gold

Many investors and market analysts believe that, since rising interest rates make bonds and other fixed-income investments more attractive, money will flow into higher-yielding investments (such as bonds and money market funds) and out of gold when rates move higher. Therefore, when the Federal Reserve raises its benchmark federal funds rate, weakness in gold should follow.

However, there's little evidence that gold is consistently weakened by federal funds rate hikes or Treasury yields. Despite some negative correlation in the 2000s, there are far too many instances of gold and interest rates rising together to say that high interest rates cause gold prices to fall.

Ultimately, the relationship between gold prices and interest rates is uncertain and unstable because gold is traded on a global market subject to forces far beyond the reach of the Federal Reserve.

An Historical Look

Even though the widespread popular belief is that there exists a strong negative correlation between interest rates and the price of gold, a long-term review of the respective paths and trends of interest rates and gold prices reveals that no such relationship exists. The correlation between interest rates and the price of gold over the past half-century, since 1970, has only been about 28%, and is not considered significant.

A study of the massive bull market in gold that occurred during the 1970s reveals that gold's run-up to its all-time high price of the 20th century happened right when interest rates were high and rapidly rising. Short-term interest rates, as reflected by one-year Treasury bills (T-bills), bottomed out at 3.5% in 1971. By 1980, that same interest rate had more than quadrupled, rising as high as 16%. In that same period, the price of gold mushroomed from under $50 an ounce to a previously unimaginable price of nearly $850 an ounce. Gold prices had a strong positive correlation with interest rates, rising in concert with them.

A more detailed examination only supports at least a temporary positive correlation during that time period. Gold made the initial part of its steep move up in 1973 and 1974, a time when the fed funds rate was rising quickly. Gold prices fell off a bit in 1975 and 1976, right along with falling interest rates, only to begin soaring higher again in 1978 when interest rates began another sharp climb upward.

The protracted bear market in gold that followed, beginning in the 1980s, occurred during a period when interest rates were steadily declining.

During the bull market in gold in the 2000s, interest rates declined significantly overall as gold prices rose. However, there is still little evidence of a direct, sustained correlation between rising rates and falling gold prices or declining rates and rising gold prices, because gold prices peaked well in advance of the most severe decline in interest rates.

When interest rates have been kept pressed to nearly zero, the price of gold has corrected downward. By the conventional market theory on gold and interest rates, gold prices should have continued to soar since the 2008 financial crisis. Also, even when the federal funds rate climbed from 1% to 5% between 2004 and 2006, gold continued to advance, increasing in value an impressive 49%.

What Drives Gold Prices

The price of gold is ultimately not a function of interest rates. Like most basic commodities, it is a function of supply and demand in the long run. While surges in supply can cause the price of gold to plummet, demand is ultimately the stronger component between the two. The level of gold supply only changes slowly, since it takes 10 years or more for a discovered gold deposit to be converted into a producing mine. Rising and higher interest rates may be bullish for gold prices, simply because they are typically bearish for stocks.

It is the stock market rather than the gold market that typically suffers the largest outflow of investment capital when rising interest rates make fixed-income investments more attractive. Rising interest rates nearly always lead investors to rebalance their investment portfolios more in favor of bonds and less in favor of stocks.

Higher bond yields also tend to make investors less willing to buy into stocks that may have high multiples or valuations. Higher interest rates mean increased financing expenses for companies, an expense that usually has a direct negative impact on net profit margins. That fact only makes it more likely that rising rates will result in lower stock prices.

When stock indexes reach new highs, they are susceptible to downside corrections. Whenever the stock market declines significantly, one of the first alternative investments that investors consider transferring money into is gold. For example, gold prices increased by more than 60% during 1973 and 1974, at a time when interest rates were rising, and the S&P 500 Index dropped by more than 20%.

The Bottom Line

Given the historical tendencies of the actual reactions of stock market prices and gold prices to interest rate increases, the likelihood is greater that stock prices will be negatively impacted by rising interest rates and that gold may benefit as an alternative investment to equities.

So while rising interest rates may increase the U.S. dollar, pushing gold prices lower (because gold is denominated in U.S. dollars), factors such as equity prices and volatility coupled with general supply and demand are the real drivers of the price of gold.