The epicenter of
gold?s intractable weakness over the past couple years has been the
Federal Reserve?s upcoming rate-hike cycle. Everyone assumes higher
interest rates will devastate zero-yielding gold, leaving it far
less attractive. This premise led investors to avoid gold like the
plague, and speculators to short sell it at wild record extremes.
But provocatively, history proves gold thrives in Fed-rate-hike
cycles.
It?s easy to
understand how the Fed?s first rate-hike cycle in over 9 years
has cast a pall over traders? gold outlook. While gold?s unique
attributes make it exceptionally valuable for portfolio
diversification, it generates no cash flows. Gold will never pay
dividends or interest, which makes it a sterile investment.
Presumably demand for yield-less assets will wane as rate hikes
naturally force yields on bonds higher.
While this bearish
gold thesis sounds perfectly logical, its core assumption is fatally
flawed. While gold has never offered a yield, investors all over
the world have still flocked to it all throughout history. They
certainly weren?t looking for a yield play, and bought gold to take
advantage of its formidable strengths on other fronts. If yield had
ever been this metal?s dominant attribute, gold would indeed be
essentially worthless.
While gold was
infinitely outgunned on yields by literally everything that pays
one, it still blasted 638% higher in the decade ending in August
2011. These returns were vastly superior to the dividend-heavy S&P
500, which slid 1.9% over that same 10.4-year span. While yielding
absolutely nothing, gold still skyrocketed 2332% higher in the
decade ending in January 1980! Bond yields were crazy-high then
too.
Gold has never
been a yield play, and never will be. The widespread antipathy
towards this leading alternative investment today on the idea that
rising rates will slaughter it is simply a flimsy rationalization
of popular bearishness. Consider how silly this yield-trumps-all
notion would be in the stock markets, where plenty of the hottest
and most-adored stocks like Amazon and Netflix have never paid
dividends.
Dividend-less
stocks are sterile investments just like gold, yet Wall Street fawns
on them. Just like gold, their prices are determined by the
intersection of trader supply and demand that has nothing to do with
their zero-yielding nature. Have you ever heard anyone argue that
higher prevailing interest rates are going to devastate stocks that
don?t pay dividends? Of course not, and that notion is just as
tenuous applied to gold.
So rather than
blindly accepting today?s groupthink belief that gold is doomed in
the Fed?s upcoming rate-hike cycle, why not check the historical
record? While this uber-dovish Fed hasn?t raised interest rates in
many years, there have still been plenty of Fed-rate-hike cycles in
modern history. So how has zero-yielding gold performed during
these past central-bank tightenings? Are rate hikes really a threat
to gold?
To find out, I
downloaded nearly a half-century of daily Federal Funds Rate
data directly from the Fed itself. This FFR is the primary interest
rate the Fed directly controls, what it sets its policy target for
when it hikes or cuts rates. The federal-funds market is where
banks lend and borrow cash deposits on an overnight basis that they
hold at the Federal Reserve. Most other interest rates key off the
Fed?s FFR.
In a mind-numbing
exercise of tedium, I looked at every decision by the Fed?s Federal
Open Market Committee that sets the federal-funds-rate target since
1971. And there were a lot of them, the FOMC changed its
federal-funds-rate target 251 times in the 46 years since. I
found that high number pretty surprising. The FOMC holds 8 policy
meetings per year, equating to around 368 over that entire span.
That implies the
FOMC either hiked or cut the FFR at over 2/3rds of its meetings,
which seems way too high. And it probably is, since the FOMC
sometimes chooses to change rates between meetings when
volatile market conditions sufficiently frighten its members. But
there has been an abundance of Fed rate hikes over the past
half-century, a large sample size to see how zero-yielding gold has
fared in their midst.
Since investors
and speculators today are very worried about how gold will perform
in a sustained Federal Reserve rate-hike cycle, I ignored
isolated FFR hikes surrounded by cuts. Since 1971 the Fed has made
6 lone rate hikes bracketed by cuts. And there were 6 more episodes
where the FFR was raised two times back-to-back but was then reduced
again. One or two isolated hikes certainly don?t make a cycle.
I decided to
generously define a Fed-rate-hike cycle as 3 or more consecutive
increases in the federal-funds rate with no decreases. These
rate-hike cycles start at the Fed?s first rate hike, and end at the
Fed?s last rate hike before it starts cutting rates again. By this
3-or-more definition, the Federal Reserve has executed 11 rate-hike
cycles since 1971. Gold?s performance in these is critical for its
outlook today.
While this red
daily federal-funds-rate data is directly from the Fed itself, it
looks a lot more volatile than most would expect. This is because
the FFR is technically a free-market interest rate determined by the
federal-funds supply and demand from commercial banks. The FOMC
doesn?t actually directly set its FFR, instead it sets a target
level which it then attempts to achieve through its own
federal-funds buying and selling.
For each
Fed-rate-hike cycle, 4 key metrics are noted. Each cycle?s total
federal-funds-rate increase in basis-point terms is shown in
red, followed by the number of separate hikes it took the Fed to
complete. That?s followed by how long each rate-hike cycle took in
months in white. And last but not least is gold?s price reaction
over the exact spans of the Fed?s rate-hike cycles in blue.
This really defies prevailing consensus.
If the Federal
Reserve?s rate-hike cycles were indeed gold?s arch-nemesis, this
zero-yielding sterile asset should have been hammered in the great
majority of them. Instead gold actually rallied through 6 of
the 11 modern Fed-rate-hike cycles! And at average gains seen
within these exact rate-hike-cycle spans of a staggering +61.0%,
gold did amazingly well. Gold often didn?t just weather rate hikes,
but thrived in them!
And in the other 5
Fed-rate-hike cycles where gold indeed lost ground as everyone
expects today, the losses were comparatively moderate. The average
losses over these exact rate-hike-cycle spans were just 13.9%.
While those are major losses, they are still a far cry from the gold
death spiral that investors and speculators seem to be expecting in
the Fed?s next rate-hike cycle. Gold has proven
very resilient.
And even though
investors and speculators have notoriously short-term memories, it?s
inexcusable that they can?t at least look to the Fed?s last
rate-hike cycle to see how gold performed. Between June 2004 and
June 2006, the Federal Reserve raised its benchmark federal-funds
rate by a total of 425 basis points in 17 separate hikes! This
more than quintupled the FFR from 1.00% at the start to 5.25% at
the end.
That last
rate-hike cycle was exceptionally intense. It was the first since
the extreme rate hikes of the 1970s with over 10 hikes, over 400
basis points of hiking, and lasting over a year. So if there was
ever a modern rate-hike cycle that should have obliterated gold as
everyone expects today, that last mid-2000s one was sure it. Since
gold yields nothing, demand for it should?ve cratered if that
argument is correct.
Yet what
happened? Gold surged 49.6% higher within that exact Fed-rate-hike
span! That?s a heck of a rally in two years, trouncing the
benchmark S&P 500 stock-market gains of just 12.0% in that same
timeframe. And those strong gold gains happened while the
federal-funds rate soared all the way back over 5%. This naturally
catapulted bond yields
much higher,
which traders argue should?ve destroyed gold demand.
And provocatively,
that last rate-hike cycle was more extreme in every way than the Fed
is telegraphing its next one will be. The federal-funds rate has
been at zero continuously since December 2008 when the FOMC panicked
in response to that year?s epic stock panic. Fed officials are very
worried about the liftoff from ZIRP sparking
a major selloff
in the US equity markets, so
they are planning very slow hikes.
After every other
FOMC meeting, the Fed publishes the economic projections of FOMC
voting members who actually set the FFR target levels along with the
presidents of the regional Fed banks. And at its recent mid-June
meeting, the latest projections by the Fed officials who make these
decisions put the FFR around just 1.5% in 2016, 3.0% in 2017, and
3.5% over the ?longer run?. That frames these coming rate hikes.
If the FOMC
gradually raises its FFR target from today?s 0.0% to 3.5% over the
next couple years, we are looking at 350bp of hikes. At 25bp per
hike which is exactly what the Fed did in the mid-2000s, this would
take 14 hikes. Such a rate-hike cycle would be less extreme than
the last one in every way, including the total FFR increase, the
duration of the tightening cycle, and the number of individual rate
hikes.
And I suspect this
coming rate-hike cycle will prove even more moderate than that.
This uber-dovish Yellen Fed is already implying a ?one-and-done?
strategy. The FOMC is so worried about triggering an adverse market
reaction that it doesn?t seem to want to keep hiking rates at every
meeting. Instead it will likely spread the rate hikes out, skipping
meetings. That makes for a much-shallower trajectory of rising
rates.
On top of that,
Fed officials? future federal-funds-rate projections have proven
wildly optimistic for years. The Bernanke Fed started releasing
these projections at every other FOMC meeting back in April 2011, in
order to promote transparency. They started including FFR
projections in January 2012. And back then, these elite Fed
officials forecast the federal-funds rate averaging 4%+ after
2014! That was sure wrong.
The key point here
is since gold rallied so strongly in that last major rate-hike cycle
in the mid-2000s, it should have no problem rallying again in the
far-milder coming rate-hike cycle. And provocatively, gold has
actually done the best in the most extreme rate-hike cycles in
modern history. The most extreme on record by every metric ran over
34.6 months ending in October 1979, where the FFR was hiked
32 consecutive times!
And that was for a
mind-boggling total FFR increase of 1075 basis points. With the
federal-funds-rate target skyrocketing all the way up to 15.5% in
that mother of all rate-hike cycles, the yields on bonds were
off-the-charts high. So if there was ever an ideal case for higher
yields sucking all the capital out of gold investment, that was it.
By traders? rationale today, gold should?ve plummeted into the abyss
in that cycle.
Yet it did just
the opposite, rocketing 178.3% higher over the exact span of
those Fed rate hikes! And that wasn?t a fluke either. There was
another extreme rate-hike cycle running over 17.4 months ending in
August 1973, where the Fed hiked 21 times in a row to catapult the
FFR 600bp higher. And again instead of collapsing as traders today
would assume, this metal soared 113.1% higher over that very span.
Obviously
something other than yields is driving gold demand! If gold
was merely the yield play that all the legions of bears wrongly
assume today, it would?ve been annihilated during those extreme rate
hikes of the 1970s. But instead it skyrocketed, making gold bulls
rich beyond their wildest dreams. Gold blasted an astounding 2332%
higher over a decade where the Fed hiked its FFR target from 3.5% to
14.0%!
Investors flocked
to gold so aggressively in that extreme-rising-rate environment that
they fomented a popular speculative mania in it. Provocatively 2 of
the 5 rate-hike cycles where gold actually fell were in the
immediate aftermath of that parabolic gold surge and inevitable
subsequent collapse. A third rate-hike cycle where gold lost ground
happened in the mid-1970s after another episode of incredible gold
strength.
So did the fourth
and fifth ones in the mid-1980s and late 1980s. So out of the 5
Fed-rate-hike cycles where gold has actually fallen, all happened
just after major secular gold highs. Gold has never fallen in a
Fed-rate-hike cycle when starting from low levels. And since
gold just slumped to a brutal 5.5-year secular low on that
extreme record
shorting attack by American futures speculators, it sure isn?t
high today.
So the evidence of
history overwhelmingly supports just the opposite of what prevailing
wisdom argues today. Rather than Fed-rate-hike cycles being
super-bearish for zero-yielding gold, they have actually proven
very bullish for it! The smart high-probability-for-success bet
to make is that gold prices will surge during the Fed?s upcoming
rate-hike cycle. Odds are gold is on the verge of a major rate-hike
upleg.
But how can that
be? Gold yields nothing, zero, zilch, nada. It?s a ?barbarous
relic?, an anachronism with no place in modern portfolios. Why on
earth would any investor want to buy gold when they could instead
own a great American company like Netflix
trading at 237x earnings, or US Treasuries yielding 2.2%? Did I
mention gold pays no dividends or interest? The Wall Street
Journal recently called gold a ?pet rock?.
The reason gold
investment demand soars in rising-rate environments is actually
quite simple. Fed rate hikes have serious adverse impacts on
stock and bond markets, which is the very reason the FOMC has
fearfully kept ZIRP in place for an unbelievable 6.7 years
now! When the Fed initially went ZIRP for the first time in its
95-year-history at that point, it swore up and down that ZIRP was
a temporary measure.
Rising rates are
devastating for stocks, especially if the stock markets are high and
overvalued, for multiple reasons. Higher-rate environments lead to
lower overall demand throughout the economy as debt-service costs
climb for everyone. And lower demand leads to slumping corporate
sales and profits, which ramps up price-to-earnings ratios to make
already-overvalued stock markets look even more expensive.
The main mechanism
through which the Fed?s ZIRP has worked to
directly levitate
the US stock markets is through corporate stock buybacks. American
companies haven?t been able to grow sales in this weak US economy,
so they?ve instead taken their excess cash and bought hundreds of
billions of dollars of their own stocks. They doubled down on these
stock buybacks by borrowing hundreds of billions more.
When the Fed rate
hikes kill ZIRP, borrowing costs for corporations will rise which
will make borrowing money to buy back stocks far less attractive and
viable. When the torrent of ZIRP-financed buybacks slows, the
dominant source of stock demand in recent years will wane. That
will make the stock markets very susceptible to a long-overdue
bear-market-grade
selloff. Higher rates are super-dangerous for stocks.
Since bond yields
will rise in concert with the federal-funds rate, bonds will become
more competitive with the big blue-chip companies that pay healthy
dividends. These stocks are yield plays, so they will see
serious selling as bond yields eclipse their dividends.
Fed-rate-hike cycles are very damaging to stock markets, especially
overvalued and overextended ones, in a variety of direct and
indirect ways.
And existing bonds
will fare even worse. As prevailing interest rates rise thanks to
the Fed?s upcoming rate-hike cycle, existing bonds will be sold off
until their prices are low enough for their fixed coupon payments to
equal the new higher yields. That means every rate hike will lead
to losses in principal for bond investors, something most of them
consider unacceptable. Bonds get crushed when rates are rising.
With both stocks
and bonds suffering serious selling pressure when the Fed is in a
tightening cycle, gold really shines. This alternative
investment generally moves counter to the stock markets, so when
they are weak is when investors rush to park capital in this
safe-haven asset. Gold not only holds its value as stocks and bonds
fall, but appreciates as investment demand for it ramps dramatically
with stocks suffering.
Historically gold
fares the best when the stock markets are faring the worst.
And that?s likely never going to change. If this upcoming
Fed-rate-hike cycle seriously weighs on the stock markets, which is
all but guaranteed in light of their lofty overvalued levels today,
gold investment demand is going to grow dramatically. Thus there
are nearly-certain odds gold will surge again during the Fed?s next
rate-hike cycle.
And the biggest
gains to be won when gold returns to favor are not in this metal
itself, but in the beaten-down stocks of its miners. Gold?s recent
record-extreme
futures shorting attack sparked a full-blown panic in gold
stocks, leaving them at
fundamentally-absurd price levels. While
they?ve rallied off those epic lows, their
massive mean-reversion higher to righteous prices is only
just beginning with far bigger gains to
come!
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The bottom line is
Federal Reserve rate-hike cycles are not bearish for gold as is
widely believed today. Gold has risen in more rate-hike cycles than
it has fallen, and the more extreme the rate-hike cycles the greater
gold?s gains. Gold surged dramatically in the last rate-hike cycle
in the mid-2000s, and rocketed higher during the most extreme
rate-hike cycles in history in the 1970s. Higher rates are actually
bullish for gold.
Contrary to the
popular myth, gold is not and has never been a yield play.
Investors diversify capital into gold when conventional stock and
bond markets are weak. And Fed-rate-hike cycles hurt stocks and
bonds on multiple fronts, greatly ramping investment demand for
gold. With today?s stock markets so high and gold so low as the
Fed?s next rate-hike cycle begins, gold?s next upleg is likely to
prove massive.
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