The Fed has finally decided to tighten monetary policy. Let’s look at the historical relationship between monetary tightening and gold performance.
- Gold shot up to $1,815 today, responding favorably to the uncertainty surrounding the Fed’s decision to reduce asset purchases.
- Many believe monetary tightening (interest rate hikes, for example) are bearish for gold. History tells us the opposite is true.
- Companies are reassessing their supply chains in a move that could rewrite the global order and reduce access to cheap labor in coming decades.
Monetary policy tightens
This week marked a turning point in our economic future, and gold is loving it. The Fed, along with other central banks around the world, have agreed to tighten monetary policy after nearly two years of unprecedented spending in the wake of COVID-19.
The Fed is currently buying $120 billion worth of treasuries and mortgage-backed securities every month. This is a process called quantitative easing, which seeks to increase the supply of money in the U.S. economy and boost growth. Since March 2020, the Fed has more than doubled its asset holdings to around $8 trillion.
The Fed plans to reduce their asset purchases by $15 billion per month starting in November. If they maintain that pace, they will completely phase out purchases by next summer. The central bank has also kept interest rates near zero since the start of the pandemic. After they finish reducing asset purchases, the Fed will likely start to raise interest rates.
Many people believe that tightening monetary policy will hurt gold. However, the last 20 years tell us the opposite is true. Gold thrives during turning points, and therefore performs well whenever the Fed makes a market-rattling decisions.
For that reason, gold’s 2022-23 outlook is bright.
Gold jumps above its trendline
Today we saw gold jump up to $1,815, confidently above its declining ceiling. The price still has substantial barriers ahead, namely the resistance at $1,833.
When the Fed Raises Rates, Gold Rallies
Usually, gold falls when interest rates rise. This is because gold competes with bonds for a safe-haven allocation in a portfolio. When interest rates are high, investors choose bonds.
For this reason, many people think that gold is doomed when the Fed raises rates. However, looking at history, we see that Fed rate hikes actually correlate with bottoms in the gold market, not tops.
The chart below shows gold’s performance since the year 2000. The line on the bottom shows the Fed Funds rate, which is the benchmark interest rate that the Fed can manually raise and lower. As you can see, the last two rate hikes have been extremely bullish for gold.
The green sections on the chart are U.S. recessions.
Interest Rate Cycles
In the last 20 years, the Fed has gone through 2 cycles of raising interest rates. The first began in 2004. The onset of the Great Financial Crisis in 2007 forced the Fed to lower the rate to near zero. The second cycle began in 2015. In March of 2020, the Fed dropped the Fed Funds rate back to near zero and has kept it there ever since.
Notice how 2004 and 2015 mark the beginnings of huge gold price rallies. In fact, the rate hike in 2015 perfectly correlates to the bottom of gold’s the bear market.
Raising the Fed Funds rate certainly does not cause gold to rally. But the economic environment that forces the Fed to raise interest rates does cause gold to rally. Gold investors should not pay attention to nominal interest rates as much as real interest rates, which are nominal rates minus inflation.
Zooming out to 1971, we see that the Fed Funds rate has a complex relationship with the gold price. However, we can confidently say that gold has historically performed very well when interest rates are hiked from zero.
The Situation Looks Good for Gold
Bond yields in recent weeks have been jumping up, down, left, right, forward, and backward trying to make sense of the current environment. Short-term bond yields such as the 2-year treasury jumped, while long-term yields actually fell.
In the past, Fed tapering has sent markets into a panic (think: taper tantrum of 2013). This time around, 80% of the S&P 500 rose. Stock market indexes are hitting all-time highs again. This might mean that investors genuinely believe economic growth is set to outpace inflation. It also might mean the market is so inundated with cash that markets are not functioning properly.
As the Wall Street Journal puts it: “A bearish interpretation is that the vast infusion of money by governments and central banks into the economy has anesthetized investors. Outbreaks of volatility in particular assets don’t spread, because there is so much money around that damps down any moves.”
Gold investors, do not despair over potential interest rate hikes. Embrace them – we believe they will trigger gold’s next price explosion.
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As always, thank you so much for reading – and happy investing!