Market News

Gold jumps at the prospect of lower US interest rates

The Federal Reserve may cut rates as early as this month, and gold has risen sharply as a result

04/07/2019

Nick Paisner

Nick Paisner

Specialist writer

Long-suffering investors in gold and gold miners finally have reason for cheer. At a little over $1,400 per ounce, the gold price is now at its highest level in five years.

The timing of the move higher is not surprising. This is the first time since 2013 that the Fed has indicated that it will be cutting – rather than raising – interest rates. That has two implications for gold.

First, it means the opportunity cost of holding it is lower: if cash in the bank is earning little interest, an investor will be more inclined to hold assets that generate no income.

Secondly, it raises the likelihood of higher inflation – and gold is widely regarded as an asset that does a better job of holding onto its purchasing power in inflationary environments than conventional currencies. Indeed, many see a relationship between gold and bond yields, with the precious metal’s price tending to rise when yields fall and vice-versa. In other words, if you invert bond yields you might observe the gold price moving in parallel – as in this chart, covering the past 12 months.

GoldpriceJuly2019.JPG

Source: FRED, Federal Reserve Bank of St. Louis. Shows 10-Year Treasury Constant Maturity Rate and London Bullion Market Gold Fixing Price.

There’s an additional factor that may be at play in the recent gold price surge: the rising risk of conflict in the Middle East. Of course, there has been plenty of geopolitical tension over the past five years that has had very little impact on the gold price. What’s different this time is that the threat of conflict between the US and Iran risks disrupting global oil supply. Investors with long memories will recall that it was oil price spikes that caused high inflation – and sharply higher gold prices - in the 1970s.

How high can the gold price go?

It’s very hard to estimate the intrinsic value of gold. Unlike financial assets, it does not generate cash flows – or “yield” – that can be used to determine its value relative to other income-producing investments.

Real supply and demand also provide little insight. The supply of mined gold is fairly steady, as is demand for physical gold for jewellery and in industry. The key variable is investor demand –from central banks, institutions and individuals  – and that will evolve with expectations for interest rates, inflation and currencies.

The history of previous rate cutting cycles is informative, though inconclusive. Gold’s price more than doubled in the wake of the Fed’s response to the financial crisis – a dramatic reaction fuelled by concern about the stability of the global financial system and the use of unprecedented monetary policy. The gold price also rose 60% during the rate cutting cycle that started in late 2000 – but did relatively little in response to interest cuts in the early 1990s.

History suggests that gold acts as a good hedge for portfolios if the US does enter recession. Moreover, the move so far has still been relatively modest – just 13% over the past year. Gold bull markets typically involve much larger gains and last for years at a time. There are also signs that institutional investors may be starting to show more interest in gold. That could result in further capital flows into the asset class that help drive it higher.

Author

Nick Paisner

Nick Paisner

Specialist writer

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