All eyes are now on the Fed and the possibility of the long-awaited first rate hike. Will the Fed raise rates? If yes, what will be the consequences for the gold market?
The story of this week is definitely the long-awaited September FOMC meeting. The Fed has been saying for months that a rate hike is very likely to happen this year, however, there is still no consensus, even among the FOMC members, whether the Fed should do this in September (if at all) and what will be the effects for the financial markets. Some claim that the Fed should raise rates as soon as possible, since the U.S. economy has already entered a period of sustainable growth, so the needed economic conditions for a tightening have been met. Others believe that the Fed will not raise interest rates in September, since the U.S. economy remains weak, there are many worldwide issues (like the Chinese slowdown and the global dampening of growth, and deflationary forces), and Wall Street is on the brink of a bear market.
Our take on this dilemma is that the Fed may have already missed its best opportunity to begin increasing interest rates, given the fact that the current economic expansion has already lasted for 74 months. This means that we are closer to the next recession than not (the average expansion in 1945-2009 years lasted 58.4 months). Thus, the Federal Reserve clearly should not raise rates in the current environment. However, the U.S. central bank may feel it has to raise rates, at least for the short term – just to retain its credibility (the zero rate was not supposed to be a permanent policy) and to gain some room for future cuts, when the recession comes (so, from the Fed’s perspective it might be the lesser of two evils).
Assuming that Yellen and her friends will hike interest rates on Thursday, what will be the possible consequences for the gold market? The standard view (which we also often presented) is that rising interest rates must weigh down on gold, as investors will seek higher returns on interest-bearing financial assets. However, the historical performance does not confirm fully this narration. For example, the federal funds rate soared from 1 to 5.25 percent between summer 2004 and 2006, while the gold price rose then from $400 to $700. There are many reasons why the increases in the federal funds rate may not move the price of gold downward. First, real interest rates are more important than nominal ones. Second, investors often buy rumors and sell facts, so what really hurts gold is the anticipation of higher rates, not the hikes themselves. Third, the Fed rate hikes are negative for the stock and bond markets, therefore, there may be outflows from them and inflows into alternative investments, like the precious metals market.
The bottom line is that the Fed will face on Thursday the dilemma whether to hike or not to hike. The FOMC members are not in an easy situation as they have missed the best moment for monetary tightening, but they risk the loss of credibility and lack of any ammunition in case of a recession. Although most investors consider the possible September hike as negative for gold, it perhaps would be better for the shiny metal if the Fed just raised rates right now and got it over with.
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Arkadiusz Sieron
Sunshine Profits‘ Gold News Monitor and Market Overview Editor
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