Gold reversed sharply lower after the Fed’s latest rate hike this week, on heavy selling from speculators and investors alike. Bearish sentiment flared on traders’ long-held belief that higher rates spell trouble for zero-yielding gold. But market history reveals the opposite, that Fed rate hikes are actually bullish for gold. This week’s Fed-induced gold dump is likely to flag gold bottoming just before a major new rally erupts.
Submitted by Adam Hamilton, Zeal:
There’s nothing gold-futures speculators fear more than Fed rate hikes. Their rationale is simple and logical. Gold pays no interest or dividends, it’s a sterile asset with returns solely dependent on capital gains. So as interest rates rise and boost yields for bonds and stocks, gold struggles to compete. Thus gold investment demand wanes as yield differentials grow between it and major competing asset classes.
This idea often leads gold-futures speculators, and to a lesser extent gold investors, to sell leading into and immediately after Fed rate hikes. Higher rates are viewed as gold’s mortal nemesis, lowering its relative attractiveness to investors. So this Wednesday after the Federal Open Market Committee hiked its key federal-funds rate for the fourth time in this cycle, gold plunged from $1276 to $1257 within a couple hours.
Fed-rate-hike fears have plagued gold for years, if not decades. Back in late 2015, the Fed had held its FFR near zero for a mind-boggling 7 years! It was preparing to end its stock-panic zero-interest-rate policy with its first rate hike in nearly a decade. I needed to better understand how Fed rate hikes really affected gold historically, so I did a comprehensive study before that hike which I just recently updated.
Before today’s rate-hike cycle was born in mid-December 2015, the Fed had executed fully 11 rate-hike cycles since 1971. Those are defined as 3 or more consecutive FFR increases by the FOMC with no interrupting decreases. Our current rate-hike cycle to which the Fed added a fourth hike this week is the 12th of the modern era, certainly nothing new. So there’s a substantial rate-hike dataset to evaluate gold’s action.
Far from being slaughtered in Fed-rate-hike cycles, zero-yielding gold actually thrives during them. Gold rallied 26.9% higher on average during the exact spans of all 11 before today’s! That was driven by huge average gains of 61.0% in the 6 of these 11 where gold rallied, and asymmetrically-modest losses averaging just 13.9% in the other 5. Two key factors governed whether gold rallied or slumped in any rate-hike cycle.
The lower gold’s price relative to preceding years heading into a cycle, the greater its gains during that set of rate hikes. And the more gradual a cycle’s hiking pace, the better gold’s gains. These conditions have been perfectly met in today’s 12th cycle. Gold entered it trading at major 6.1-year secular lows, and there has never been a more-gradual Fed-rate-hike cycle! These rate hikes have indeed proven gold-bullish.
While the fat lady has yet to sing on today’s 12th cycle, the 11th is historical fact. It ran from June 2004 to June 2006. During that span, the FOMC hiked at every meeting for 17 consecutive hikes! All these catapulted the FFR 425 basis points higher, more than quintupling it to 5.25%. If Fed rate hikes are truly gold’s kryptonite, that aggressive cycle should’ve killed it. Yet gold blasted 49.6% higher over that exact span!
History decisively proves higher rates aren’t a problem for gold investment demand. Between January 1970 and January 1980, gold skyrocketed a stupendous 2332% higher. The FFR averaged 7.1% in that span, extreme levels by today’s standards. From April 2001 to August 2011, gold soared 640% in still another secular bull. Despite the Fed’s ZIRP implemented in December 2008, the FFR averaged 2.1% then.
So clearly the ever-popular thesis that zero-yielding gold can’t compete in a higher-rate environment is dead wrong. This week’s aggressive gold selling by speculators and investors alike on a hawkish Fed was emotional and irrational. All three previous Fed rate hikes in this 12th cycle have actually proven very bullish for gold. This week’s 4th hike shouldn’t play out any differently after the kneejerk selling abates.
To help illustrate why this week’s rate hike is really bullish for gold, I built a couple charts. They examine the holdings of gold-futures speculators and gold-ETF investors during the Fed’s current rate-hike cycle. The gold-futures data comes from the weekly Commitments of Traders reports. We’ll start on this speculator side since these gold-futures traders wield extremely-outsized influence over short-term gold price action.
Way back in mid-December 2008 in the epic fear maelstrom of the first stock panic in a century, the Fed implemented its zero-interest-rate policy. Nearly 7 years after ZIRP’s wildly-distorting artificially-low rates were forced on markets, the FOMC warned of an imminent rate hike at its late-October-2015 meeting. So gold-futures speculators fled in terror, jettisoning longs while simultaneously amassing huge short positions.
It was back then as gold plunged on fears of the first rate hike in nearly a decade when I did my original study on gold in Fed-rate-hike cycles. In financial markets, popular wisdom is always wrong at extremes. The consensus view and bets are the wrong ones to make. All that heavy selling pummeled gold to a brutal 6.1-year secular low as the Fed hiked its FFR for the first time in 9.5 years in mid-December 2015.
On that actual FOMC-rate-hike day, gold managed to bounce 1.1% off such deep lows. But the next day foreign traders panicked, igniting heavy selling here in the US. So gold plunged 2.1% to that secular low of $1051 in the wake of the first rate hike of the Fed’s 12th cycle of modern times. Naturally gold sentiment was off-the-charts bearish. With ZIRP over, there was just no way zero-yielding gold could compete any more.
Yet what happened? Over the next 6.7 months gold powered 29.9% higher and birthed a major new bull market! This was partially driven by the same gold-futures speculators terrified of Fed rate hikes adding a staggering 249.2k long contracts while covering 82.8k more short ones. That was the equivalent of 1032.4 metric tons of gold buying, a major amount in a world gold market with 4315.0t of total demand in 2016.
If Fed rate hikes are so bearish for gold, why didn’t it collapse 30% over the half-year after that first hike in nearly a decade instead of soaring 30%? The Fed stayed on hold for an entire year after that, so the sharp gold plunge in the second half of last year had nothing to do with rate hikes. An improbable series of extreme anomalies centered around the Trumphoria stock-market rally crushed gold 17.3% lower by late 2016.
Gold was stuck in a sickening freefall after the election with the next Fed rate hike looming imminently in mid-December. The Fed not only hiked the FFR a second time, but its outlook on 2017 rate hikes was more hawkish than expected. Markets including gold-futures speculators were looking for two, but the so-called dot-plot summary of FOMC members’ predictions instead showed three more rate hikes this year.
So gold tanked hard on that FOMC-rate-hike day, falling 1.4%. The next day this selling continued with another 1.2% drop to $1128. Again traders were exceedingly bearish on gold. With the Fed proving its hiking wasn’t just a one-off deal, how could sterile gold rally in a higher-rate world? Yet the next day after that Fed rate hike, gold’s brutal post-election plunge bottomed. Gold surged out of that very Fed rate hike!
Gold-futures speculators get so worked up about Fed rate hikes that they sell too much leading into them and in their immediate aftermaths. That spawns selling exhaustion, leaving big room to buy in order to mean revert those extremely-bearish gold-futures bets back to more-normal levels. So excessive gold-futures shorts are covered and new longs are bought. This catapults gold higher in the wake of rate hikes.
You’d think these elite traders would learn, maybe spend a few hours digging into some historical data on how gold really works instead of succumbing to herd emotions and losing money. But nope, they are too darned stubborn. So just a couple months after gold had bottomed and surged on the Fed’s second rate hike of this 12th cycle, Fed-rate-hike fears crept in again! The FOMC was paving the way for a third rate hike.
Oh the horror, that would surely prove the final nail in zero-yielding gold’s coffin. That third rate hike was special, as it would actually finally confirm that a new Fed-rate-hike cycle was indeed underway. Gold-futures speculators fled on soaring Fed-rate-hike odds per the federal-funds futures. These handicap the likelihood of FOMC rate changes at upcoming meetings based on the bets of elite speculators and hedgers.
The second upleg of gold’s young bull, which were respectively birthed by the Fed’s second and first rate hikes of this cycle, was powering higher into late February. At that time futures-implied rate-hike odds at the FOMC’s upcoming mid-March meeting were just 22%. But incredibly over just the next 6 trading days, top Fed officials collectively did so much hawkish jawboning that rate-hike odds nearly quadrupled to 86%!
The FOMC won’t hike until markets expect it, as the Fed doesn’t want to risk surprising the markets and sparking a serious bond or stock selloff. 70% rate-hike odds per federal-funds futures is the minimum necessary for the Fed to actually hike. So as the certainty crossed that and hit 95% just before the mid-March FOMC meeting, gold-futures speculators again fled. That pounded gold sharply lower into that rate hike.
Gold fell as low as $1198 the day before that FOMC meeting. And as usual when markets give it a free pass on hiking rates via very-high federal-funds-futures odds, the Fed indeed executed its third rate hike and confirmed its 12th cycle had indeed begun 15 months earlier. The gold-futures speculators were so hypnotized by the hawkish Fedspeak that they expected the 2017 rate-hike outlook to climb from three to four.
But it didn’t, so they were once again caught offside in a big way. You’d think it would get frustrating to keep losing money on making big bearish gold-futures bets on Fed-rate-hike fears. But these guys can’t seem to learn. So they flooded back into gold with a vengeance on mid-March’s very FOMC-rate-hike day, blasting it 1.9% higher! That ignited a major new rally that would soon push gold to new second-upleg highs.
See the pattern here friends? Gold yields nothing, so everyone assumes it can’t fare well with higher prevailing interest rates. Thus the gold-futures speculators who dominate short-term price action thanks to their extreme leverage wax super-bearish leading into any expected Fed rate hike, and sell aggressively. The resulting gold drops spread that bearishness like a virus, infecting everyone else into believing that fiction.
Then the Fed indeed hikes, and the irrational gold-futures selling sometimes continues on momentum for another day or two. But it doesn’t take long for the speculators to realize gold isn’t collapsing on that Fed rate hike. And their collective bets became so bearish that they have far too many shorts and far too few longs. So big mean-reversion gold-futures buying soon erupts in the immediate wake of Fed rate hikes.
Fed-rate-hike cycles have been very bullish for gold historically for the past half-century or so. The first three Fed rate hikes of this current 12th cycle have proven very bullish for gold, igniting a major new bull, sparking its second major upleg, and driving a sharp rally within its uptrend. So why on earth is anyone the least-bit worried about the Fed’s fourth rate hike this week? It too should fuel big gold-futures buying.
History inarguably proves that Fed rate hikes are bullish for gold! Full stop. Sooner or later even those gold-futures speculators will realize this. The reasons are as simple and logical as those of that fallacy’s that argues higher rates are the mortal nemesis of zero-yielding gold. But before I delve into them, let’s briefly switch our focus to gold-ETF investors instead of gold-futures speculators. They are major gold players.
The world’s leading and dominant gold ETF is the American GLD SPDR Gold Shares. It effectively acts as a conduit for the vast pools of stock-market capital to flow into and out of physical gold bullion. GLD’s holdings are reported daily, offering the highest-resolution read available of gold investment capital flows. Fed rate hikes not only spark speculator buying, but the ultimately-far-more-important investor buying.
Way back heading into December 2015 when the Fed was warning of finally staking ZIRP, investors wanted little to do with gold. The Fed-levitated stock markets starting with the open-ended QE3 in early 2013 had convinced investors stock markets were essentially riskless. If the Fed was effectively backstopping stock markets so they would rally indefinitely, why bother diversifying stock-heavy portfolios with gold?
Gold is a unique asset that tends to move counter to stock markets, making it the ultimate portfolio diversifier. Gold investment demand wanes when stock markets are high and volatility is low, generating extreme complacency among investors. So GLD’s physical gold bullion held in trust for its shareholders hit a 7.3-year secular low the day after that initial Fed rate hike of this cycle back in mid-December 2015.
That quarter-point hike wasn’t much, but after 7 years of ZIRP it signaled the hyper-easy Fed was finally shifting back to tightening mode. Thus the stock markets sold off sharply in early 2016 as traders feared the Fed was becoming a stock headwind instead of a tailwind. The S&P 500 dropped 13.3% in several months leading into mid-February 2016. That was its biggest correction since mid-2011, spooking investors.
As they realized stock markets don’t climb forever but can fall too, investment capital flooded back into long-neglected gold through GLD. All gold’s quarterly price action last year, from Q1’s surge to Q4’s plunge, can be directly explained by stock-market capital flowing into and out of gold via GLD shares. And that’s the key to understanding why gold thrives in Fed-rate-hike cycles contrary to expectations of the opposite.
Gold is essentially an anti-stock trade. Investors shun gold when stock markets are high, so investment demand collapses and gold languishes. But as lofty stock markets start rolling over into what could be inevitable major bears between the bulls, gold investment demand explodes. Investors rush back to GLD shares to start diversifying their stock-heavy portfolios. Higher perceived stock-market risk boosts gold demand.
This is why Fed rate hikes are bullish for gold. While higher rates indeed lift prevailing yields, they drive major losses in existing bonds and stocks. Fed rate hikes directly drive bond selloffs, as issued bonds are sold down until their lower yields equal new higher prevailing ones. But Fed rate hikes also indirectly drive stock selloffs through a couple key mechanisms, more competitive bonds and harder stock buybacks.
Many investors seek incomes, so ZIRP and the still-super-low rates since forced countless traditional bond investors into dividend-paying stocks. Fed rate hikes make new bond investment relatively more attractive than these yield stocks, leading to selling. The crazy-low rates also fueled a record boom in corporate stock buybacks. American companies borrowed cheap money to use to buy back their own stocks.
This stock-price manipulation is greatly curtailed by Fed rate hikes, which naturally make borrowing more expensive. History has also proven in spades that the monetary tightening inherent in rate-hike cycles is a serious headwind for stock markets. It’s this stock weakness spawned by Fed rate hikes that drives gold investment demand higher bidding up its price. Gold’s yield differential has absolutely nothing to do with it.
Speculators dumped gold futures after this week’s fourth rate hike because they expected the weak recent economic data to lead the FOMC to lower its collective 2017 rate-hike forecast below the three from mid-March’s dot plot. That didn’t happen, as this Fed is hellbent on hiking regardless of the data as long as the stock markets are near record highs. But this week’s FOMC was exceptionally ominous for stocks.
For years along with ZIRP, this extreme stock-market bull was levitated by Fed quantitative easing. That involved the Fed literally conjuring up trillions of dollars out of thin air to buy bonds, ballooning its balance sheet to grotesque levels. This week the FOMC laid out the groundwork for starting to reverse QE through the opposite quantitative tightening. That is likely to start as early as the Fed’s September meeting!
QT is every bit as bearish for stock markets as QE was bullish for them. Less Fed bond buying as it gradually allows maturing bonds to roll off its books will force interest rates higher. That’s a huge problem for wildly-overvalued stock markets precariously kept aloft by abnormally-low interest rates! QT’s downside impact on stock markets ought to drive exceptional gold investment demand in the coming months and years.
So just like every other Fed rate hike in this cycle, and the past Fed-rate-hike cycles, this week’s Fed rate hike and first-ever QT warning is super-bullish for gold. It’s very likely to again birth a major gold rally as this kneejerk selling passes. Investors can play this coming upside via that leading GLD ETF, or through the stocks of the gold miners with superior fundamentals. They are deeply undervalued with vast upside potential.
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The bottom line is this week’s latest Fed rate hike is actually bullish for gold. Kneejerk selling based on a false premise isn’t uncommon, but that soon passes. Both this young gold bull, and its current second major upleg, were born the very next days after Fed rate hikes. Gold has not only already powered higher in today’s newest Fed-rate-hike cycle, but has thrived on balance in all the past cycles of this modern era.
Fed rate hikes hurt stock markets, which boosts gold investment demand for diversifying portfolios. And this week’s FOMC announcement heralding the first-ever quantitative tightening is exceedingly bearish for these Fed-levitated record-high stock markets. As they inevitably roll over, gold investment demand will once again surge and catapult gold much higher. This trend will generate great wealth for prudent contrarians.
Adam Hamilton, CPA
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