Gold has declined dramatically over the last few months based on a temporarily stronger dollar and fears that the Federal Reserve might raise its near-zero Fed Funds rate to 1.0% or even 1.5% early next year.

The anti-gold crowd says “gold pays no interest” and therefore any increase in nominal interest rates puts gold at a disadvantage.  However, if you examine recent interest rate increases, these fears are unfounded.

Gold Nearly Doubled the Last Time the Fed Raised Interest Rates

Gold doubled from 2004 to 2006, when the Fed raised interest rates dramatically.  Like now, the Fed was very slow in deciding to raise rates from historically low levels of around 1%.  Short-term interest rates in 2003 and 2004 were super-low because the Fed feared that raising rates would stall a weak recovery. 

The slow recovery of 2003 and 2004 – like today – was called a “jobless recovery.”  The unemployment rate peaked at 6.3% in June of 2003, more than a year after the previous recession ended.  But when the unemployment rate fell to 5.5% in the summer of 2004, the Fed started raising rates, slowly at first….

Despite widespread fears of a slowing economy if the Fed raised rates, the economy continued to flourish in 2004 to 2006. The stock market continued to rise and the jobless rate continued to fall, so the Fed kept raising rates for a two-year period, increasing the Fed Funds rate from 1% to over 5% by mid-2006.

You would think that gold would fall in a time of rapidly-rising rates.  After all, gold had been trapped in a narrow trading range of $300 to $500 per ounce for 23 years – ever since 1981.  Surely, a sharp increase in rates would kill the gold bull market in its cradle.  But when rates started rising, gold nearly doubled from $385 per ounce in mid-2004 to $725 per ounce when the Fed stopped raising rates in mid-2006. 

As this table shows, gold rose the most rapidly when interest rates rose to over 4%.  Furthermore, during this time of rising gold and rising interest rates, the U.S. dollar did not rise!  The dollar fell sharply from 2002 to 2008.  In the midst of that run, from 2004 to 2006 – when the Fed raised rates – the dollar decline was slower, but it still fell.  Today, everyone assumes that the dollar is strong because the euro is cutting rates while the Fed is TALKING about raising rates, so the “smart money” is selling low-yielding euro to buy the about-to-be-slightly-higher-yielding dollar. But the last time the Fed raised rates, the dollar fell.

The Same Thing Happened in 1994 (sort of)…

and 1979 (in Spades!)

Something similar happened 20 years ago, although not as dramatically as in 2006. In early 1994, Fed Chairman Alan Greenspan engaged in a year-long pre-emptive strike against inflation fears by issuing SEVEN interest rate hikes in less than a year, pushing the Fed Funds rate from 3% in early February 1994 to 6% as of February 1, 1995.  You would think that gold would collapse, but it was actually trendless. In fact, gold rose from $370 in April 1994 to $395 in April 1995.  By contrast, stocks fell for most of 1994.

The most dramatic example of gold rising during a time of rising interest rates came during the late 1970s, culminating in gold’s most meteoric spike in history, when gold tripled in less than six months, at a time when the Fed Funds rate doubled (from about 10% to 20%) during the Fed’s war against inflation.

In the late 1970s, gold bottomed out at $103 in September of 1976, when the Fed Funds rate was around 5%.  During the rest of the decade, interest rates rose and so did gold.  The Fed funds rate reached 6% in August 1977; 7% in April 1978; then 8% in August 1978; 9% in October 1978 and 10% at year-end 1978. 

The Fed Funds rate started shooting up sharply in late 1979, when Paul Volcker took over the reins at the Fed. Rates rose from 10% to 11% in August 1979, then to 13% in October and a shocking 250-basis point increase to 15.5% in late October, 1979.  The Fed Funds rate reached 20% in February 1980.  This sharp rise in the Fed Funds rate was mirrored in the gold price, which tripled in less than six months, rising from $282.70 on August 6, 1979 to $850 on January 21, 1980.  Surely, this meteoric rise of both gold and interest rates should put to rest the old canard that gold loses its comparative advantage as rates rise.

The Press Continues to Repeat the “Rising Interest Rate Gold-Killing” Myth

The September 15, 2014 Barron’s Commodities Column tried to explain the correlation between rising interest rates and declining gold in a column titled “Gold’s Shine is Gone,” by Mary de Wet.  (We’re not picking on the author.  She was merely summarizing what the Wall Street experts say about gold now.)

In general, New York-based financial journals tend to follow existing trends.  When gold is down, they will write stories like “Gold’s Shine is Gone,” but when gold returns to favor, the same publications will no doubt print articles like “Gold Glitters Again.” (But isn’t it better to buy gold when the price is down?)

First, Barron’s quoted a Bank of America Merrill Lynch analyst, who said: “Rates have a strong influence on gold, given they represent opportunity costs for the non-yielding metal.”  By now, however, you know that this comment ignores the historical examples I’ve cited from 1979, 1994 and 2004 to 2006. 

Barron’s also tells us that “Gold was a star after the financial crisis, with investors buying the metal to protect their wealth against potential inflation or currency devaluation.”  That’s not a very accurate description of the 10-year gold bull market from 2001 to 2011.  Most of gold’s gains came before 2008, before the 2008 financial crisis.  Gold rose from $271 on the day before 9-11 (September 10, 2001) to $1,011 on Saint Patrick’s Day, March 17, 2008.  That 273% rise came before the financial crisis.  During the financial crisis of 2008, gold actually declined, falling to a low of $710 during October of 2008.

Here are the annual price changes of gold from 2001 to 2012.  The smallest calendar-year gain was 2008.  Notice how the gains from 2002 to 2007 are larger (+140%) than the gains from 2007 to 2012 (+101%). 

Barron’s also says, “Gold can’t even count on Asia to prop up prices.  China and India, the world’s top consumers of the metal, have scaled back on their purchases this year.”   That’s not exactly true, because measuring Asian demand depends on which month you measure.   Mary de Wet admits this in the same Barron’s article: “Commerzbank expects China and India to increase their gold imports in the coming months and forecasts gold prices to end the year at $1,300 per ounce.  Gold purchases in India usually ramp up ahead of Diwali, a Hindu festival and gold-giving occasion that falls on October 23 this year.”

Asian Gold Demand is set to Rise Again

The Asian markets are price sensitive, so demand actually increases when the price of gold goes down.

• In China, the Shanghai Gold Exchange (SGE) opened September 18.  Prior to the grand opening, SGE imported almost $16 billion worth of gold this year (through August 31).  Global giants like UBS, Goldman Sachs, JPMorgan Chase and other large banks are now trading gold in Shanghai.

• In India, gold imports rose 176% in August (vs. August, 2013), partly due to artificially low totals in August 2013, right after India established its gold import duties. India imported over $2 billion in gold in August of 2014, partly due to loosened restrictions by the Indian government. 

• Singapore will offer new gold contracts next month.  Thailand is also considering setting up a spot gold exchange, and Dubai is also launching a new gold contract.  These and other new gold markets in and around Asia could help to lift the gold price by year’s end, or early in 2015.

In contrast to Asia, U.S. investors don’t like to buy an investment when it’s cheap.   Most investors will wait to see a clear rise before jumping on board.  However, they may miss the strong early surge that way.  The good news is you don’t have to decide when the bottom is in place.  You can dollar-cost average some gold purchases now and then spend the same amount next quarter…and the quarter after that.

In the long run, the fundamentals are still in place to lift gold higher: More central bank are buying gold; Asian middle-class wealth is rising, fueling more demand.  On the supply side, there is a slowdown in gold discoveries (due to lower prices) resulting in a decline in new gold supplies.  Rising demand from consumers and central banks and slower supply growth inevitably leads to higher prices, but we don’t know the timing of gold’s current bottom, so smart buyers will buy a little now… and a little more later.