An unexpected slowdown in the CPI caused a sharp drop in the dollar, incentivizing buyers to chase gold and silver.
Inflation slows down
Last month’s inflation report came in at 3.0%, quite a bit lower than expected. The slowdown in inflation makes it much more likely for the Federal Reserve to cut its benchmark interest rate, which currently sits at a 23-year high. The CME FedWatch tool indicates a 94.5% probability that rate cuts will begin in September.
Impact on the dollar, yields, and gold
When rates fall, investors tend to move their capital away from dollar-denominated assets toward other countries where they can earn higher yields. As a result, the value of the US dollar tends to be correlated with domestic interest rates.
This week, expectations of lower rates put immediate pressure on the US dollar. Treasury yields also dropped.
As expected, a weaker dollar and lower yields triggered a huge buying spree for gold. Gold is now rocketing toward its all-time high of $2,450, achieved in May of this year.
Silver is bouncing around $31.50/oz, continuing an impressive 32.4% performance since March.
There is very strong momentum in both gold and silver on daily, weekly, and monthly time scales. Over the longer term, record gold demand from central banks is expected to support higher metals prices.
Why does gold rise when interest rates fall?
Gold is inversely correlated with interest rates for two reasons:
1. Opportunity Cost
Gold is a non-yielding asset. Investors prefer to earn a yield. When interest rates rise, the opportunity cost of holding gold increases, therefore decreasing demand. Conversely, if interest rates fall, gold becomes more attractive.
2. Money Supply
Falling interest rates correlate with increasing money supply. This is quite literally how the Fed cuts the Fed Funds Rate (all other things being equal).
To lower interest rates, the Fed buys government bonds from banks and credits their reserve accounts with new money. This increases the amount of loanable funds in the economy, therefore decreasing the cost to borrow money. When banks have more reserves, they can turn around and extend more loans to consumers and businesses, increasing the amount of money in circulation.
Long story short, when the Fed buys government bonds, the money supply grows. Increasing money supply makes gold more attractive because gold has a strictly limited supply. The price of gold tracks the growth of the money supply over time.
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