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The Fed’s Rate Increase Sends the Dollar Up and Gold Down: An Irrational Knee-Jerk Reaction Creates a Unique Buying Opportunity
The first small (0.25%) increase in the fed funds rate in nine years – after seven years of interest rates near zero – pushed the U.S. dollar up and gold down. With the European Central Bank (ECB) recently cutting rates further below zero (to -0.3%) and the Japanese yen undergoing massive quantitative easing, the dollar is the Best of Breed among the three largest currencies in the world – so the dollar keeps rising.
Most commodities, including gold, are universally priced in U.S. dollars, so the price of gold declines as the dollar rises. As a result, gold has fallen from about $1200 at the start of 2015 to $1050 last Friday. With only a few trading days left in 2015, gold is bound to record its third straight negative year after 12 straight years of rising prices (from 2001 to 2012). Still, gold is up in terms of over a dozen major global currencies, including the Canadian dollar, in 2015 (we’ll publish the complete list at the end of the year)
Historically, Gold has Usually Risen as Rates Rise
The current theory – a gigantic blind spot – is that gold will go down as interest rates rise, since “gold offers no interest” and high interest rates will take investors away from gold and toward cash deposits. The first problem with that theory is that 0.25% is hardly “high interest.” The dollar still offers some of its lowest returns of the last century at rates well below 1%. Secondly, the dollar will not keep rising forever. When the currency eventually declines, gold could soar. Thirdly, history flies in the face of this theory.
We have written about this phenomenon before, but gold’s decline on the Fed announcement last week makes these historical studies all the more relevant as we move into 2016. Specifically, earlier this year, HSBC published a study showing that gold historically has rallied “shortly after the Fed announced the first rate hike in the last four tightening cycles.” Here’s the last such occurrence, in 2004:
Gold took a steeper-than-expected fall last week since the Fed added that they may raise rates three or four times in the new year. Previously, many observers (including us) expected a “one and done” rate increase in December. That may still be the case – especially if the evidence of deflation and economic slowdown increase in early 2016 – but the gold bears unloaded more of the yellow metal because of the assumption that gold will likely decline further if the Fed raises rates to 1.5% or higher by year-end 2016.
Adam Hamilton of Zeal Research also confirmed the fact “that gold tends to thrive during Fed-rate-hike cycles.” The mother of all rate cycle increases came in the late 1970s, when the Prime Rate hit 21% and gold soared from under $300 to over $800 in barely six months – from July 1979 to January 1980.
“Between January 1970 and January 1980, gold skyrocketed 2332% higher! Over that exact span the benchmark federal-funds interest rate the Fed targets averaged 7.1%, compared to zilch for gold…. Then between April 2001 and August 2011, gold soared 640% higher. Despite the advent of ZIRP back in late 2008, the fed funds rate still averaged 2.1% during that span.” -Adam Hamilton, Zeal Research
Germany’s Commerzbank made the same observation earlier this month:
“During the last cycle of rate hikes, the gold price was able to gain 11% within one year following the first rate hike … [T]he gold price should be able to make similarly strong gains in 2016, even if the U.S. dollar appreciates further, unlike last time.”-Commerzbank
For those interested in income, bonds and high-yield stocks are admittedly better, but gold is a superior investment for the low-yielding cash portion of most portfolios since it offers the potential of capital gains far superior to any currency in history, including the dollar. (Gold is up 3,000% to the dollar since 1970.)
Has the euro (or any other currency) done better than gold, long-term? No. The euro was formed in 1999 at $1.18 to the dollar. It has been as low as 85-cents and as high as $1.50 during its 16-year life. When the euro was born, gold was $288 per ounce, so gold cost 244 euros per ounce. With gold at $1065 and the euro at $1.08, gold costs 986 euros today, so gold is up 304% in euro terms since the euro was born.
This year, gold will likely rise in terms of the euro, so gold has been beating the euro all year long, when you consider that euro bank rates have been BELOW zero. If you put yourself in the place of a European investor, you must face the choice of losing a guaranteed 0.3% on your euro bank deposits, or own a commodity which has beaten all currencies over the long-term and has the potential for stronger gains.
Maybe that’s why Germany’s Commerzbank advises buying gold for 2016, even if the Fed raises rates as many as four times over the next year. In their gold forecast from earlier this month, Commerzbank says: “We expect to see prices perform better in the new year once the Fed has implemented its first rate hike in mid-December, thereby dispensing with one key factor that has been weighing on prices this year.”
Commerzbank sees “robust demand from Asia” that will push gold to “$1200 per troy ounce by the end of 2016.” No matter what happens to the dollar, they believe that the main driver of gold prices will be Chinese and Indian demand, along with central bank gold buying. They see gold rising even faster in 2016 in euro terms. Commerzbank thinks the gold price in euros is likely to rise more than gold in U.S. dollars. Commerzbank said it sees gold at 1165 euros by the end of 2016, up almost 20% from today.
Demand in India, Russia and China Remain the Key in 2016
Without rising demand, gold is headed for long-term doldrums, but the combination of “peak production” (predicted to happen this year) and rising global demand augurs for a gold price rise in 2016. China and India still provide half the global demand, so we must look there first (and most often). New York traders are liable to be the last to get back onto the gold bandwagon – after prices rise by $200 or more per ounce.
China’s central bank continues to stockpile gold. For six years (from 2009 to 2015), China didn’t tell us how much gold they were buying, but the People’s Bank of China (PBOC) recently announced that it holds 1,743 metric tons of gold, up 60% since 2009. Russia has also been stockpiling central bank gold almost every month over the last five years. Russia expanded its gold holdings by over 77 tons in the third quarter, bringing its total central bank holdings to 1,352 metric tons. Central banks in Kazakhstan, Malaysia, Belarus, Jordan, Ukraine and the United Arab Emirates have also added to their gold holdings.
China’s gold buying is all the more impressive since Beijing has actually reduced its $4 trillion in foreign exchange (as of early 2015) to $3.5 trillion, fighting collapses in their real estate and stock markets. In other words, China has sold a lot of their dollar and euros, but they have added to their gold supplies.
China’s growing middle class is also buying more gold than ever. Withdrawals from the Shanghai Gold Exchange (SGE) through the end of November reached 2,362 metric tons, well above the previous full-year record (set in 2013) of less than 2,200 metric tons. Gold demand in China will likely increase in the next two months in advance of the Chinese New Year celebration, which falls on February 8 in 2016.
Imports of gold to India, the world’s second-biggest consumer, more than doubled in November, driven by festivals and weddings and aided by gold prices that approached a six-year low. Gold imports rose to 101 metric tons in November, more than double October’s 45 tons, according to India’s finance ministry.
While gold is down in dollar terms this year, it is important to remember that gold is up in several global currencies, including the Brazilian real, Canadian dollar, Mexican peso, Australian dollar, New Zealand dollar, Norwegian krone, Russian ruble, Turkish lira and a few other currencies. What’s equally important is that gold is still DOWN in terms of the countries with the greatest demand – China and India – as well as Japan and several other Asian nations. This means that gold is still affordable in terms of the Chinese yuan, Japanese yen, Indian rupee and other Asian currencies, so cost-conscious Asians will likely keep buying. (Unlike most Western traders, who buy on the rise, Asians tend to buy when prices are low.)
Traders in New York are still overly bearish, with near-record short positions on the “paper gold” markets (primarily gold ETFs and futures contracts), but that can provide the kindling for a more rapid gold price rise when the bears are forced to “cover their shorts” (i.e., buy back the gold they previously borrowed in order to sell). That’s one more reason why it pays to be a contrarian on gold and to buy gold “too early.”
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