Gold in Fed-Rate-Hike Cycles 2 - Adam Hamilton (03/31/2017)
Gold suffered heavy selling in early March leading into the Fed’s latest rate hike. Speculators frantically dumped gold futures ahead of the Fed’s meeting as implied rate-hike odds soared. This is nothing new. This key group of traders has long feared Fed-rate-hike cycles, convinced they are the mortal nemesis of zero-yielding gold. But this view is highly irrational, as history proves gold actually thrives in rate-hike cycles!
The Federal Reserve’s primary and dominant tool for setting monetary policy is its target for the federal-funds rate. Commercial banks are required to maintain reserve balances at the Fed, with necessary levels fluctuating daily based on each bank’s underlying business activity. So banks with surplus reserves can lend them on an overnight basis to other banks running deficits through the federal-funds market.
The interest rate at which these transactions happen is the federal-funds rate. But the importance of the FFR extends far beyond that specialized inter-bank market. This critical interest rate is effectively the baseline from which all other US interest rates are set! So this small FFR tail wags the giant dog of the price of money across the entire US economy. The prevailing FFR levels affect virtually everything else.
Federal-funds futures trade to enable hedging and speculation on future FFR-target changes by the Fed’s monetary-policy-setting Federal Open Market Committee, which meets 8 times per year. All this futures trading collectively implies traders’ perceived odds of the FOMC hiking or cutting its FFR target at its coming meetings. Gold-futures speculators watch these futures-implied Fed-rate-hike odds like hawks.
Back in late February, these odds of the Fed raising rates at its mid-March meeting were running at just 22%. The FOMC doesn’t want to surprise and shock markets, which risks igniting major selloffs in both bonds and stocks. So it doesn’t boost its FFR target unless a rate hike is universally expected, with market odds running well over 70% leading into a meeting. At 22% odds, gold was near $1264 on February 27th.
But then top Fed officials began aggressively jawboning on a potential March rate hike. They started a concerted and relentless campaign to convince markets that a rate hike was likely at the FOMC’s March 15th meeting. In just 4 trading days, those futures-implied rate-hike odds nearly quadrupled to 80%! It was an unprecedented blindingly-fast massive shift in perceptions, blowing past that 70% hiking threshold.
By March 9th, those odds were running 91% which was nearly certain. With the markets suddenly so convinced another rate hike was coming, the FOMC would be foolish to squander that opportunity. In that short 9-trading-day span where rate-hike odds skyrocketed from 22% to 91%, gold plunged 4.5% on very-heavy selling by futures speculators. There is nothing these guys fear more than Fed rate hikes!
The same thing happened leading into the previous rate hike in mid-December 2016. Over the 6-week span from the prior FOMC meeting to that hiking one, gold plunged 10.1%. That span encompassed the election, so the resulting Trumphoria stock-market surge driving a gold mass exodus was a bigger factor. But futures speculators still fled on rate-hike fears. The same thing happened a year earlier with no election.
The Fed hiked rates for the first time in 9.5 years in mid-December 2015. Over the 7 weeks between the preceding FOMC meeting warning of a likely hike and that hiking one, gold plunged a similar 9.1%. I could go on and on. Recent years have seen many examples of heavy gold-futures selling arising on hawkish FOMC statements, Fed officials’ hawkish FFR forecasts, and hawkish jawboning by these guys.
Gold-futures speculators have even rushed for the exits on strong US economic data supporting more-hawkish stances by the Fed! Nothing influences gold-futures trading more than what these speculators expect the Fed to do with its federal-funds-rate target. And unfortunately their gold-futures trading has a wildly-disproportionate impact on prevailing gold prices. Gold is quite literally hostage to Fed expectations!
The futures speculators’ logic is simple and apparently sound. Gold yields nothing, making it a “sterile investment”. Thus investors are more likely to want to own it when prevailing interest rates are low. But as Fed rate hikes force all interest rates higher, gold becomes relatively less attractive. Higher yields on other assets entice investors to shift their allocations away from gold. So gold investment demand wanes.
If this rate-hikes-are-bad-for-gold thesis that’s universally believed today is true, history would prove it out. But it doesn’t. Between January 1970 and January 1980, gold skyrocketed 2332% higher. During that exact span, the federal-funds rate averaged a stupendously-high-by-today’s-standards 7.1%! And all the while gold still yielded zero, just like it always has. Yet gold still soared in a gargantuan secular bull.
Between April 2001 and August 2011, gold soared up 640% in another secular bull. Despite the advent of the Fed’s wildly-unprecedented zero-interest-rate policy back in mid-December 2008, over that span the FFR still averaged 2.1%. That’s far higher than today’s 0.9% levels deeply feared by gold-futures speculators. Clearly the idea that rate hikes and higher prevailing rates spell doom for gold hasn’t proven true.
Back in late 2015 leading into an expected first Fed rate hike in nearly a decade, I did a comprehensive study on how gold performed in past Fed-rate-hike cycles. I had never seen one before, and needed to understand how this gold-and-FFR relationship worked historically. So I downloaded nearly a half-century of daily federal-funds-rate data directly from the Fed itself, and merged it into a gold-price spreadsheet.
Amazingly the FOMC had changed its FFR target a whopping 251 times in that 45-year span from early 1971 to before its first recent hike in mid-December 2015! Since the FOMC meets 8 times per year, that equates to about 360 meetings which implies the FFR target was changed at well over 2/3rds of them. But that’s misleading, as the FOMC calls emergency unscheduled meetings in exceptionally-volatile markets.
Since gold-futures speculators are convinced Fed rate hikes are kryptonite for gold, I scoured decades of the Fed’s historical FOMC statements and FFR data to find all the hikes. In order to be considered a rate-hike cycle, multiple sequential hikes without intervening FFR cuts are required. 6 times between early 1971 and late 2015, the Fed had made lone rate hikes that were bracketed by cuts. Those aren’t cycles.
The Fed’s vacillation didn’t stop there. 6 additional times the FOMC raised its target FFR twice back-to-back before it was reduced again. It’s hard to argue that two hikes make a cycle. The most-generous definition possible for a Fed-rate-hike cycle is 3 or more consecutive FFR increases with no interrupting decreases. By this conservative metric, the Fed had executed fully 11 rate-hike cycles between 1971 and 2015.
Interestingly March 2017’s latest rate hike made for the third one since December 2015, which formally confirmed we are now in the Fed’s 12th rate-hike cycle since the early 1970s! That, along with gold’s sharp early-March selloff leading into this latest hike, prompted me to revisit this critical research. How has gold actually performed historically during the exact spans of all the previous Fed-rate-hike cycles?
If the futures speculators are right that Fed rate hikes are bad for gold, history would clearly show it. Yet the exact opposite has proven true! These charts highlight every Fed-rate-hike cycle in modern history in light red. These cycles are defined by the FOMC’s FFR targets, which don’t always perfectly match the troughs and peaks in the federal-funds rate because the Fed actually doesn’t directly control the FFR.
It is technically a free-market interest rate determined by federal-funds supply and demand. The FOMC sets an FFR target, and then attempts to actively manipulate the FFR to it with open-market operations directly buying and selling in the federal-funds market. While the Fed has become more sophisticated in bending the FFR to its will over the decades, there have been significant deviations from targeted levels.
These updated charts include both the actual federal-funds rate in light red with the FOMC’s FFR target on top in dark red. Depending on market conditions, it can take tens of billions of dollars of Fed trading to force the free-market FFR to converge with the FOMC’s target. Gold is superimposed over all this FFR data in blue. Gold-futures speculators need to seriously study this history totally contradicting their worldview.
Finally a half-dozen key data points are noted for each Fed-rate-hike cycle. Starting at the top is the total increase in basis points, hundredths of a percent. That’s followed by the number of individual hikes in each cycle, and their average basis-point increases per hike and per month. Next comes the duration of each Fed-rate-hike cycle in months, followed by gold’s price performance during each cycle’s exact span.
Nearly a half-century of data is a commanding sample, encompassing all possible market conditions ranging from raging secular bulls in stock markets to a full-on once-in-a-century stock panic. If American gold-futures speculators’ fervent belief that Fed-rate-hike cycles slaughter zero-yielding gold is correct, it would absolutely show up historically in such a massive data set. But gold actually thrives in rate-hike cycles!
Since the Fed’s current 12th one of modern times likely isn’t finished yet, let’s start with the previous 11 between early 1971 and late 2015. On average during the exact spans of all of them, gold rallied 26.9% higher! Those are serious gains during events supposed to slay gold investment demand on widening yield differentials. Provocatively gold’s Fed-rate-hike-cycle performance trounces that of the stock markets.
I did a similar study in late 2015 looking at the flagship S&P 500’s performance during these same Fed-rate-hike cycles. This leading stock index saw average gains of just 2.8% during their exact spans. That is nearly an order of magnitude smaller than gold’s 26.9%! While the idea that gold vastly outperforms the stock markets during Fed-rate-hike cycles seems obnoxiously heretical today, it is absolutely true historically.
Gold’s average gains across all modern Fed-rate-hike cycles come from rallying big in 6 while slumping modestly in the remaining 5. In the majority where gold rallied, it averaged huge gains of 61.0% over their exact spans! And in the other 5 where gold fell, its average losses were asymmetrically small at just 13.9%. It turns out there are two key characteristics of Fed-rate-hike cycles that govern whether gold wins or loses.
The first is obvious, how gold is priced when the Fed births a new rate-hike cycle. If this metal is already trading at high levels relative to preceding years, it tends to slump as the Fed tightens. Fed rate hikes aren’t bullish for gold late in a major bull. By that time the great majority of willing investors have already bought, and sentiment is too greedy to be sustainable. Fed-rate-hike cycles won’t trump gold’s bull-bear ones.
The second is how fast the Fed actually hikes rates. The more gradual the rate hikes, the more bullish it is for gold. This makes sense given the extreme anxiety gold-futures speculators have over higher rates. The faster the Fed hikes, the more psychological pressure to capitulate on gold due to the perception a higher yield differential makes this metal less attractive. This is still less important than gold’s cycle entry price.
Without exception, gold rallied in every modern rate-hike cycle shown in these charts if it entered them at low price levels. But if gold was already high after years of rallying when the Fed started hiking rates again, this metal fell. Again gold’s own bull-bear cycles overrule any Fed-rate-hike cycle influence. As in all markets, gold’s relative buying price is the dominant driver by far of its ultimate investment returns.
But the pace of hiking is an important secondary determinant of gold’s rate-hike-cycle fortunes. During those 6 of 11 cycles where this metal soared 61.0% higher on average, the hiking pace was gradual. It averaged just 35 basis points per hike and 24bp per month. In contrast in the other 5 cycles where gold fell 13.9%, the FOMC’s average hiking pace was radically steeper at 110bp per hike and 141bp per month!
By these standards, gold’s performance in the Fed’s newest 12th rate-hike cycle since 1971 ought to be incredibly bullish. Just before the Fed started hiking again in December 2015 after nearly a decade of no hikes dominated by the ZIRP era, gold slumped to a brutal 6.1-year secular low. That’s about as low as gold’s ever been relative to recent history entering a Fed-rate-hike cycle, leaving huge room for big buying.
And as of mid-March, the FOMC has hiked three times for 75 basis points total over 15 months. That is the most-gradual Fed-rate-hike cycle ever witnessed by far, averaging just 25bp per hike and a mere 5bp per month! There’s never been an FOMC more timid in hiking rates than Janet Yellen’s, she has always been an uber-dove. Thus despite two rate hikes in 3 months now, today’s cycle will remain the most-gradual ever.
So gold is really set up to soar dramatically during this rate-hike cycle’s span! That’s already happened despite all the irrational selling by the gold-futures speculators leading into each of the Fed’s latest rate hikes. As of the very mid-March rate-hike day, gold had powered 15.1% higher since the day before the initial rate hike in mid-December 2015. That’s despite incredibly-euphoric stock markets weighing on gold sentiment.
With gold enjoying perfectly-bullish conditions both entering and within this 12th modern Fed-rate-hike cycle, its ultimate gains should easily exceed that +61.0% winning average. And that’s darned exciting for smart contrarian investors. A garden-variety 61.0% gain from gold’s close the day before that first rate hike a couple Decembers ago yields a conservative gold rate-hike-cycle upside target way up at $1709!
That’s another 36.5% higher from this week’s levels, implying massive additional gains by the time the Fed’s rate hikes run their course. It just blows my mind that sophisticated gold-futures speculators can’t take a few hours to understand how gold has really performed historically during rate-hike cycles. With the extreme levels of leverage they run, you’d think they’d do some serious due diligence to understand odds.
While gathering and crunching all this data since 1971 certainly isn’t trivial, why not simply look to the last Fed-rate-hike cycle for some guidance? Between June 2004 to June 2006, the FOMC hiked the FFR at every meeting for 17 consecutive hikes. These totaled 425 basis points, more than quintupling the federal-funds rate to 5.25%. If higher rates and yield differentials slay gold, it should’ve plummeted at 5%+.
Yet during that exact span, gold actually surged 49.6% higher! There is literally zero chance Yellen’s hyper-easy FOMC will hike rates 17 times, or get anywhere close to 5%. Yellen constantly rationalizes why she and her henchmen believe the new normal federal-funds rate won’t be higher than 3%. Given this Fed’s history of over-promising and under-delivering on rate hikes, I’d be surprised to see them get over 2%.
If gold could power 49.6% higher over two years in the mid-2000s in such an extreme rate-hike cycle compared to today’s, similar gains should be easy this time around. That would push gold up to $1588, again far higher than today’s levels. It’s sad most investors and speculators today don’t have a clue how bullish Fed-rate-hike cycles are for gold, as they’ve been deluded by the “zero-yielding gold” propaganda.
Gold has always yielding nothing, and thus never been a yield play. Gold serves an entirely different purpose than bonds in investors’ portfolios. They don’t directly compete as the gold-yield fallacy implies, but complement each other. Gold is a unique asset that tends to move counter to stock markets, making it the ultimate portfolio diversifier. It is a hedge against stock-market weakness, essential portfolio insurance.
Stock-market fortunes, not prevailing interest rates, are the biggest driver of gold investment demand. In euphoric stock markets like today’s late in major bulls, investors feel no need to prudently diversify their portfolios with gold. They foolishly assume stocks will keep rising indefinitely, so they way over-allocate to lofty, overvalued stocks. But when stock bulls inevitably yield to subsequent bears, the tables quickly turn.
Gold investment demand soars for portfolio-diversification purposes, driving gold sharply higher. That’s exactly what happened in late 2015 and early 2016 soon after the Fed’s initial rate hike of this 12th cycle. The stock markets sold off hard in a significant correction, rekindling gold demand. The resulting heavy gold investment buying catapulted this metal into its first new bull market since 2011, which continues today.
While recent months’ extraordinary Trumphoria stock-market surge in the wake of the election masked it, Fed rate hikes are very bearish for overvalued stock markets. When the Fed artificially suppresses rates as it did to the ultimate extreme in that 7-year ZIRP era before its initial December-2015 hike, stocks are bid up to otherwise-unsustainable valuations. Their low dividend yields aren’t competing with normal bond yields.
But once the Fed hikes and starts normalizing rates, the rising bond yields suck capital back out of the lofty stock markets. Bonds held to maturity are far-less risky than highly-volatile stocks, and unlike gold the dividend-paying stocks dominating the major indexes are indeed yield plays. Gold thrives in Fed-rate-hike cycles because they are so damaging to stock markets, which rekindles gold investment demand.
Another major underpinning of gold-futures speculators’ erroneous belief that rate hikes are bad for gold is the idea they are bullish for the US dollar. But history doesn’t bear that out either. Entering that last Fed-rate-hike cycle in the mid-2000s, the US Dollar Index was already very low relative to recent years. Yet it still actually lost 3.8% while the FOMC hiked its FFR target 17 times in a row from 1.0% to 5.25%!
The gold-futures speculators are dead wrong, gold thrives in Fed-rate-hike cycles! Thus every time they irrationally panic and emotionally dump gold futures leading into a likely Fed rate hike, treat it like a gift. Those are great opportunities to aggressively buy the resulting bargains in both gold and the stocks of its miners. That proved true again in early March, as the entire gold sector soared right after the Fed hiked!
With a newly-confirmed Fed-rate-hike cycle now well underway, investors can ride gold higher with this metal itself or shares in the flagship GLD SPDR Gold Shares gold ETF. But the greatest gains by far will be won in the stocks of the gold miners with superior fundamentals. Their profits and thus stock prices really leverage gold’s upside, so a carefully-handpicked portfolio of elite miners will far outperform gold.
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The bottom line is history proves gold thrives in Fed-rate-hike cycles. Rising rates are very damaging to stocks and bonds, leading to surging gold investment demand for prudent portfolio diversification. The lower gold’s price levels entering Fed-rate-hike cycles, and the more gradual their hiking pace, the better gold performs. That makes gold’s prospects in today’s newest Fed-rate-hike cycle exceptionally bullish.
Gold not only languished at deep secular lows when the Fed started hiking a couple Decembers ago, but this rate-hike cycle’s pace is the slowest ever by far. And the hyper-dovish Yellen FOMC is still falling all over itself to convince markets this relaxed pace will continue to dawdle. Thus gold is perfectly set up to enjoy a massive Fed-rate-hike cycle rally well exceeding the already-big historical winning averages.
Originally posted here.
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