Why Gold Prices & Interest Rates Move in Tandem

Whenever the Federal Reserve announces the interest rates, gold prices also react. If interest rates are increased, gold prices fall, and vice-versa, indicating a negative correlation. Sometimes an explanation is offered that when interest rates go up, the higher returns attract foreign capital and demand for dollars. The increased demand for dollars raises the US dollar-exchange rate. This higher return on dollar makes gold less attractive and hence the gold prices drop.

This is the theory put forward by television channels and economic courses around the world. One may refer to the above theory as the “Maggi Theory of Gold”. The theory is applicable for the first two minutes of trading after announcement of an interest rate. Beyond that, the historical evidence has been quite opposing to what the above theory suggests.

Gold is not an interest?bearing instrument. So “other things being equal” any interest?bearing instrument should be preferable. It does not matter whether the interest rate is 1% or 50%, one would be worse off holding gold. Therefore, it is not the interest rate that controls gold prices, but the “other things” that are assumed to be equal.

To find what are the “other things”, we need to go to the basics of investing. Benjamin Graham says that an investment operation is one which, upon through analysis, promises safety of principal and an adequate return. Most would agree that it should at least be equal to the risk-free interest rate and a risk premium for holding a risky asset class. When inflation is expected to be high, investors favor gold as a mechanism for protecting their purchasing power. Consequently, when confidence in a currency is high (which means low inflation), gold prices and interest rates would be low.

Now the question arises how high the gold price would go in the next decade of rising interest rates. In the previous interest rate cycle of 1970 to 1983, prices increased nearly 20 times, from $35 to about $675. This time around, price started from $260, so will they exceed $5000? One could argue that the move appears exaggerated, as gold price fixed by the US Government in 1970 at $35, was artificially low. On the other hand, one could make a case that in every economic aspect, be it fiscal deficit, consumer debt, grade deficit, etc., the US is much worse than it was during the 1970s. Hence gold could be headed for an even greater move.