Interest Rates and Gold
As expected the Federal Reserve raised the range of it’s benchmark interest rate by 1/4 of a percentage point this week. Now that interest rates in the US may trend higher, we wanted to do a piece on what raising rates could mean for Gold.
Also, in the second part of the article we include some recent developments in the junk bond market that may signal higher rates are coming and there will be little that the Central Banks can do about it.
We can only look at history as guide to see how Gold performed during previous interest rate cycles to speculate on what might happen this time around. However, there is one big difference between past cycles and today.
China is now the world largest Gold buyer. When you combine this with other countries such as India, Russia and the Middle East, the majority of the global Gold demand on an annual basis is coming from non-western countries. This alone should minimize any negative effect from higher US interest rates.
But lets look at some past data to try and draw some conclusions on how Gold might behave in a higher rate environment. The conventional wisdom of the mainstream financial media says that higher interest rates are not good for the Gold market. But the data suggests otherwise.
Higher Interest Rates Could Be Bullish For Gold
As we mentioned in our last Gold and Silver update, during Gold’s last bull market in the 1970’s Gold rose along with interest rates. According to an article on ZeroHedge, nominal interest rates more than doubled to 20% during the 1970’s.
During this time Gold increased 24 times from $35 to $850 an ounce. (Source: ZeroHedge/GoldCore 2015 April 12th) The most interesting data points are in the latter part of the decade. From 1977-1980 interest rates increased from 4% to over 20%.
While interest rates were rising dramatically Gold had it’s greatest gains. During the same 3 year period Gold rose from about $200 to over $800 an ounce. Some may argue that the 1970’s were different than today because inflation became a real problem.
It’s true that inflation, at least as of now, is not a real threat in the short term. So let’s take a look at a data from a different time period. The ZeroHedge/GoldCore article reports that from October 2003 to October 2006 US interest rates jumped from 1 percent to 3 percent.
During this same period Gold’s cumulative return was almost 60%.
The Price of Gold Has Increased after the last 4 Fed Rate Hikes
In July, HSBC’s Global Research team published research showing that the price of gold has increased after the last four Fed rate hikes.
“History shows that gold prices also fall leading into a rate hike and generally rise, though sometimes with a lag, after the first rate hike… Investors are apt to unload gold in anticipation of tightening monetary policies. This negative pressure is sustained until the Fed announces a rate hike, which then eases the negative sentiment towards the yellow-metal. This explains the subsequent rallies in gold that occurred shortly after the Fed announced the first rate hike in the last four tightening cycles”. (Source: Casey Research 2015 December 7th)
Because we live in such unprecedented times it is difficult to speculate on how things will play out during the next rising interest rate cycle which could be upon us now. One thing Gold investors should take to heart is that investors turn to Gold during times of financial turmoil.
So even if Gold turns down during a rising rate environment, lower Gold prices will likely be short lived. Also, those who own Gold in Euro’s or Pound’s could still see gains if Gold declines in US Dollar terms. Stimulus measures in the UK and EuroZone will likely only increase which could weaken Euro area currencies.
Junk Bonds Signaling Trouble
Let’s get back to the discussion on interest rates. One of the big risks to the global economy is the credit markets. After years of quantitative easing and historically low interest rates, investors have been searching for ways to seek a higher return.
One of the ways investors have done this is by investing in junk bonds. Junk bonds are non-investment grade bonds that carry a higher risk of default. Companies that issue junk bonds have a lower credit rating and thus have to pay a higher interest rate to attract investors.
Do to a slowing global economy, problems in the junk bond market are starting to emerge. According to an article in ZeroHedge, junk bond prices recently had their biggest single day drop in 4 years. The article went on to say that US high yield bond prices have collapsed to their lowest level since July 2009. (Source: ZeroHedge 2015 December 11th)
Too give CelticGold readers an idea of the level of concern market participants have with the junk bonds market right now, below are some of the headlines over the last two weeks or so.
- Why Smart People Are Worried About a Junk Bond Crisis
time.com 2015 December 14th
- Bad omen: Junk bonds are getting trashed
usatoday.com 2015 December 11th
- The Junk Bond Market Is Collapsing
investmentresearchdynamics.com 2015 November 25th
- "It's An Epic Bloodbath" - Presenting The 2015 Junk Bond Heatmap
zerohedge.com 2015 December 13th
Default Rates are Rising
According to Standard & Poor’s, companies worldwide have defaulted on $95 billion in debt so far this year. This is the largest year of defaults since the credit crisis in 2009. (Source: wallstreetonparade.com December 2nd)
The credit markets are flashing red right now due to the impact a fed rate hike will have on the debt markets. Corporate defaults happen when a company misses a payment on a loan, files for bankruptcy or has to restructure the loan.
The Ripple Effect
While junk bond prices have already been heading lower this year, the plunge accelerated recently when it was reported by multiple media outlets that investment firm Third Avenue, blocked investor redemptions from its high yield-heavy Focused Credit Fund. (Source: ZeroHedge 2015 December 10)
According to the story the company has entered a “plan of liquidation” as the fund has lost some 27% in 2015, with assets plunging by a 66%. Now that investors are perceiving more risk in the high yield market, the question now is will this cause a ripple effect?
The next ripple has hit this week. According to Bloomberg, Lucidus Capital Partners, a high-yield credit fund, has liquidated its entire portfolio and plans to return the $900 million it has under management to investors next month. (Bloomberg: 2015 December 14th)
The story reports that a redemption notice from a significant investor in October triggered Lucidus’s decision to start winding down the portfolio.
It looks like the junk bond market could turn into a major story next year.
Debt and Interest Rates
According to a report by consulting firm McKinsey & Company, since the great recession global debt has increased by $57 trillion, which has outpaced GDP. Over the last several years borrowing costs have plunged to record lows which has encourage more debt accumulation.
Companies have issued an unprecedented $9.3 trillion of bonds since the financial crisis. The scale of borrowing is reaching record levels.
According to Bloomberg, Anheuser-Busch InBev NV said it obtained $75 billion in loans to back it’s acquisition of SABMiller Plc. This is the biggest corporate loan on record. (Source: Bloomberg 2015 November 11)
While a small percent of corporate debt is classified as junk bonds or “high yield debt” the markets are very likely approaching a trend change where the historic ultra low interest rate environment is coming to an end.
This means debt is going to be more expensive to service, which is going to add even more stress to the financial system, especially in a slower growing global economy.
As many alternative financial writers have pointed out, rising interest rates will create a crisis, and so will negative interest rates. This is why physical Gold is an asset worth considering.
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