Gold goes up in times of economic uncertainty. It’s the ultimate form of insurance.
I’ll bet you’ve heard that dozens of times. In fact, that’s the sort of stuff I say.
However, gold goes up even when there isn’t any economic drama fuelling the price rises.
Yep, I say that even as the precious metal has fallen 4.95% from its year-to-date high of US$1,295 an ounce at the start of June. In fact, if you’re like me and you’re holding your gold in Aussie dollars, you’re down 8.2%. The fall has been much greater as the Aussie dollar has gotten stronger against the US dollar. In six weeks, the Aussie dollar has climbed from 74.99 US cents to a peak of 78.33 cents overnight.
Gold’s recent downward trend has even spooked hedge funds managers. According to Bloomberg, the top money boffins of the world believe that ‘monetary tightening’ in the US and Western Europe will kill off any chance of a precious metals rally.
[Click to enlarge]
No doubt this mass exodus is pressuring the gold price. Fund managers are so quickly dumping precious metals, the majority of the ones surveyed by Bloomberg are now ‘net-short’ silver. In other words, they have very bearish view of the precious metals.
Bloomberg tells us that the hedge funds surveyed believe looming higher interest rates will be bad for the yellow metal.
Yet rising interest rates are good for gold. And the money managers could be jumping out of the gold price far too soon, missing out on the long-term gains the precious metal can offer.
The price of gold does tend to spike during times of uncertainty. But it can also rise during calm market periods, if not as dramatically.
First, a quick history lesson.
Let’s go back in history for a moment. The 1970s were one of the first times gold was allowed to react to the global economic situation.
President Richard Nixon officially ended the US dollar’s peg to gold on 15 August 1971. With many other currencies fixed to the US dollar, after this day, the world moved to a complete fiat currency system.
The 1970s saw the oil embargo from Arab countries to the US create a crippling shortage of oil. Inflation was rampant. While the average US inflation rate for the decade was 7.25%, it peaked at 11.35% in 1979.
Australia wasn’t spared either, with consumer prices rising on average 10%, after peaking at 16% in 1975. Our economy plunged into debt as the Whitlam government continued with its spending promises. Wages grew at 13%, which contributed to inflation, but hurt businesses. There were building material shortages…and then, suddenly, there were thousands of people sacked from their jobs.
With a free-floating gold rate following Nixon’s decree, gold soared, reflecting the uncertainty of the times.
Have a look at the long-term gold price chart below. The first red arrow on the left tracks the price of gold during the 1970s. From 1973 to early 1980, the gold price rose from US$65 to US$665…an incredible 923% gain.
[Click to enlarge]
Now, you may have noticed the black circle between 2004 and 2008…a period of relative calm and bullishness in global markets. I will get back to that in a moment, as that is what I really want to show you today.
But first, let’s look to the next period of major uncertainty. One I’m sure you remember all too well.
A decade ago, the world got a glimpse of how layered financial markets are. The near collapse of the banking system was felt everywhere. Suddenly, complex financial instruments with no physical asset backing were topics no longer limited to corporate boardrooms.
It’s no surprise, then, that the next big price spike for gold started in 2007. The rally continued until the end of 2011. Starting at US$665, the price of gold peaked at US$1,805 an ounce. This is the red arrow on the far right — a period when gold gained 171%.
Therefore, gold rises during periods of uncertainty. But you knew that.
The Federal Reserve Bank has raised rates twice already for 2017. And the speculation is rife about whether there will be one or two more rate increases this year. The Canadian central bank, the Bank of Canada, joined the rate raising party last week and lifted the cash rate from 0.5% to 0.75% — the first move in seven years.
If the US is raising rates, that means the danger is out of the market; and surely that means gold’s bull run is over, right?
Think about it. The main reason the US government is increasing rates is because the Fed believes the economic outlook is ‘stable’. Furthermore, their data modelling shows that inflation is increasing, and raising the cash rate will prevent inflation getting out of control.
I don’t actually believe any government statistic. The data is manipulated to suit government agendas over the years. But this is what we have to work with.
The important thing to remember is that rising inflation is good for gold. If inflation is rising, that means your cash is buying less. In other words, your purchasing power is going down.
Many people assume the price of gold only rises in times of economic uncertainty.
The idea is, if everything is fine, gold has nothing to react to. Therefore, rising interest rates should cause the yellow metal to fall.
It’s the same old argument each time. Gold doesn’t pay any yield, so, as interest rates rise, investors will move their money to higher-yielding assets.
But that’s not necessarily true. Do you recall the black circle on the gold price chart above? You know, the one from the calm period between 2004–08? Let’s have a look at what happened during that time.
Source: Sprott and Bloomberg
[Click to enlarge]
What you see here, denoted by the yellow line, is the gold spot price from June 2004 through to June 2006.
This two-year period saw the metal gain 62% as it climbed from US$385 per ounce to finish June 2006 at US$625. It peaked at US$730.40 in May 2006.
Now look at the red line. This shows you when the Federal Reserve Bank met, and then increased the cash rate…at each meeting. During this time, the Fed raised rates from 1% to 5.25%. Yet the gold price still rallied.
Granted, gold didn’t rally as hard as it did during the turbulent economic times of the 1970s or during the global financial crisis. But this chart gives you a clear indication that gold can — and usually does — go up in the face of rising interest rates.
This calm period shows what is possible for the price of gold. History may be getting ready to repeat itself. Remember, nobody notices the price of gold when it is climbing steadily.
For Markets & Money
Editor’s Note: This article was originally published in Money Morning.