What The Fed Rate Increase Means For Gold

The words on everyone’s lips during the past week: “Why did the gold price rally after the Fed raised interest rates?

On March 15, 2017, the U.S. Federal Reserve board voted to raise the federal funds rate for the second time in three months. The move further signaled the end of the nearly decade-long experiment with ultra-low interest rates.

In times past, gold and silver prices sometimes declined after interest rates hiked. There is a superficial logic behind this: because physical metals don’t offer recurring dividends or interest payments, experts expect investors to ditch metals in favor of financial instruments, such as bonds or CDs. Gold didn’t retreat this time. Instead, the spot price for the yellow metal jumped up nearly two percent overnight.

Gold “Priced In” the Rate Hike Before It Happened

The average Econ 101 textbook might say that interest rate increases cause gold to fall, but those books are well behind the times. Gold investors and gold dealers had fair warning about the rate hike before March.

Investors are forward-looking by nature. In fact, it’s the very job of speculators to make best guesses about future asset prices and trade-futures contracts, which reflect events that have not yet taken place. Many gold investors expected a Fed hike in the first quarter of 2017. Gold likely traded at a slow discount for the first few months of the year. (In fact, you can check the betting markets to see what the odds of a future rate hike might be.)

Fed Chairwoman Janet Yellen gave testimony to the U.S. House and Senate committees in February, wherein she telegraphed a potential hike and suggested the economy was on solid footing. It’s a well-known fact that the Fed tries to smooth equity markets by hinting at its plans.

Gold investors listen to those same signals. When savvy traders expect a hike in March, they begin adjusting their portfolios in December, January, and February. By the time the rate hike hits, metals markets can keep a steady pace because they’ve already “priced in” the rate hike.

Why the Experts Are Often Wrong About Gold

Forward-looking investors might be the reason that gold didn’t fall sharply after Fed officials announced the rate hike. Even so, that doesn’t explain why gold prices rose after the hike.

This brings us to another important point: the experts are often dead wrong about gold. To many experts, gold is just another asset in your portfolio. Such experts tend to dislike gold; after all, gold bullion comes with storage fees and doesn’t pay interest. This is their first mistake — they treat gold analysis as they would stock or bond analysis. Gold doesn’t work that way.

Another mistake that these experts make is that they trust, implicitly, that the Federal Reserve can “manage” the economy successfully. If the Fed does it’s job correctly — just like how the Econ 101 textbooks say it can — then gold should drop after the Fed wrestles the country out of a prolonged economic slump.

Veteran gold investors know better. They don’t trust the operations of central banks. They know the Fed has a remarkably poor track record, that the Fed has slowly killed the U.S. dollar, and that these slow Fed hikes may well be a sign of weakness, not strength, if they prick the bubbles in bonds, stocks, or private consumer debt.

A Different Look at the Federal Reserve and Gold

The real truth is that gold is a complicated asset, and its value depends on a lot more than the FOMC’s rate machinations. In fact, over the past 30 years, gold prices rose more often than they fell after the Fed raised interest rates. Gold often reacts better after a hike than after a cut.

Gold investors don’t look at precious metals as a replacement for bonds or money market accounts. Gold isn’t a short-term instrument to help generate 8-10% returns each year. This is a very critical lesson to understand; once you do, it clears up a lot of misconceptions and poor predictions.

Moreover, the Federal Reserve is not an innocuous institution. The standard (incorrect) view is that Fed officials objectively evaluate the economy, run a few equations, pull some levers, and seamlessly navigate an otherwise rudderless economy. The truth is that the Fed is made up of politically inclined, self-interested, and flawed human beings who are eager to protect equity markets because it helps their legacy.

More and more people realize that the U.S. government owes an unsustainable $20 trillion in debt. They realize that the Federal Reserve, which ran experimental monetary policy with recklessly low interest rates for much of the past 10 years, messed up the Dot-com crisis of the 1990s and the housing and financial bubbles of the mid-2000s.

During such political and economic uncertainty, paper assets lose their luster. Gold, on the other hand, shines brightest when times are toughest. So, when the Federal Reserve raises interest rates, investors increasingly distrust the meddling. They see the potential for a big bubble bursting. And, at least for many, they see a need to diversify away from investments that rely on proper Fed management.