Gold thrives in rate-hike cycles
Gold’s deep new secular lows of recent weeks were fueled by American futures speculators’ overpowering fear of Fed rate hikes. They believe zero-yielding gold is doomed in a higher-rate world, so they dumped gold futures at astounding record rates. The problem is history proves just the opposite, that gold tends to thrive during Fed-rate-hike cycles. This revelation is a super-bullish near-term omen for gold.
Some brief context is essential to frame gold’s apparently dire predicament today. Late July saw gold crushed to new secular lows by a record extreme gold-futures shorting attack brazenly executed to blast through long-side stops and foment panic selling. But this burst selling soon fizzled, leading to a major gold bottom in early August. Over the subsequent few months, gold carved an impressive new uptrend.
By the middle of the day on October 28th, gold had climbed all the way back up near $1182 which was 9.0% above its artificial early-August low. But that very day the Federal Reserve’s Federal Open Market Committee that makes monetary policy threw the markets an unexpected curve ball. The FOMC inserted a surprise statement sentence warning “whether it will be appropriate to raise the target range at its next meeting”.
This shocked traders, as it was the first time the Fed made a direct reference to a possible imminent rate hike since it first implemented its zero-interest-rate policy ages ago in December 2008. This catalyzed the already-bearish American gold-futures speculators into selling with reckless abandon. Starting that very day, gold would fall for 14 of the next 15 trading days for an 8.4% total loss in just several weeks.
This gold-futures selling was off-the-charts astounding, occurring at extreme record rates far beyond anything ever witnessed before. That span since the Fed’s hawkish late-October surprise saw the most single-week speculator gold-futures short selling ever by huge margins. Multiple-week records of gold-futures selling by this same group of traders were also shattered, as explored in depth in my essay last week.
American futures speculators wreaked havoc on gold since that last FOMC meeting because they are utterly convinced the coming Fed-rate-hike cycle will devastate gold. Their thesis sounds logical on the surface. Gold yields absolutely nothing, so as rising rates force yields on bonds higher investors will abandon gold to migrate into bonds. The higher prevailing interest rates, the less attractive gold will be.
Nearly all traders take this rate-hikes-will-doom-gold outlook as gospel today. But it is fatally flawed on a blindingly-obvious front. Gold has always yielded zero, yet it still powered higher in gargantuan secular bulls. Between January 1970 and January 1980, gold skyrocketed 2332% higher! Over that exact span the benchmark federal-funds interest rate the Fed targets averaged 7.1%, compared to zilch for gold.
Then between April 2001 and August 2011, gold soared 640% higher. Despite the advent of ZIRP back in late 2008, the FFR still averaged 2.1% during that span. With gold enjoying gargantuan secular bulls that greatly multiplied investors’ wealth in far-higher interest-rate environments than today’s, it is readily apparent gold isn’t valued as a yield play. That whole idea is utterly nonsensical for an asset paying no cash.
Because it yields nothing, gold is often derided as a “sterile investment”. But that is rather ironic since that definition includes all stocks that don’t pay dividends. Saying gold is doomed in this next Fed-rate-hike cycle is as silly as claiming wildly-popular zero-yielding stocks like Facebook, Amazon, Netflix, and the company formerly known as Google will be obliterated as investors flee them to buy higher-yielding bonds!
Investors have flocked to gold for millennia for the same reason they buy stocks, because they want to buy low to later sell high as demand grows. American futures speculators’ contention that sterile gold is somehow a yield play is utterly absurd, both historically and logically. Gold is similar to any stock that doesn’t pay dividends from an investment perspective, a price-appreciation play where yields are irrelevant.
American futures speculators are so whipped up into their groupthink gold-to-zero hyper-bearish frenzy that they can’t see this truth. The gold-price impact of their resulting extreme record gold-futures selling has been so dire that investors have fallen into this same mental trap. But the prudent investors and speculators transcend herd emotions to study how gold actually performed during historical Fed-rate-hike cycles.
Last summer I did a comprehensive study of this very question, the first I’ve come across. This proved a quite-tedious project. 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. It turned out the FOMC has changed its FFR target a whopping 251 times in the 45 years since 1971. This aggressive frequency really surprised me.
Since the FOMC meets 8 times per year to make monetary-policy decisions, that equates to about 360 meetings over that span. And given the lack of changes in the FFR since late 2008, it is hard to believe the FOMC changed the FFR at well over 2/3rds of its meetings. But during particularly-volatile market episodes the FOMC calls emergency unscheduled meetings, which tend to result in panicked rate cuts.
With the Fed’s first rate hike in the 9.5 years since June 2006 universally expected next week, it is the historic FFR increases we are interested in. And futures speculators aren’t devastating gold only because they fear a single quarter-point hike, but because they are expecting a new Fed-rate-hike cycle. So I painstakingly scoured the Fed’s historical FOMC statements and FFR data for federal-funds rate hikes.
In order to be a rate-hike cycle, multiple sequential hikes are required without intervening FFR cuts. It turns out the FOMC has made 6 lone rate hikes bracketed by cuts since 1971. There were an additional 6 more times the FFR target was raised twice back-to-back before it was reduced again. There’s no way one or two isolated hikes make a Fed-rate-hike cycle. It’s amazing how much the Fed has vacillated on rates!
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 FOMC has executed fully 11 rate-hike cycles since 1971. Gold’s actual performance within these historical cycles, starting and ending on the exact days of their first and last hikes, is critical for understanding its likely performance in this coming cycle.
These charts highlight every Fed-rate-hike cycle in modern history in light red. They don’t always match the actual troughs and peaks in the federal-funds rate perfectly because the Fed doesn’t directly control the FFR. It is technically a free-market interest rate determined by federal-funds supply and demand. That is where commercial banks borrow and lend their cash deposits held at the Fed on an overnight basis.
Instead the Fed sets an FFR target, which it then attempts to achieve through open-market operations where it directly buys and sells in the FFR market. While the Fed has gotten more sophisticated over the years in bullying the actual FFR to its target, there are still deviations. Bending the free market to its will can literally take tens of billions to hundreds of billions of dollars of trading, is certainly isn’t a trivial task.
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 is followed by the number of individual hikes in each cycle, and their average basis-point increases per hike and per month. Then comes the duration of each Fed-rate-hike cycle in months, followed by gold’s price performance over cycles’ exact spans.
Nearly a half-century of data encompassing all possible market conditions ranging from raging secular stock-market bulls to a full-on stock panic is a hefty sample size. If American futures speculators’ fervent belief that zero-yielding gold gets killed during Fed-rate-hike cycles is correct, it would absolutely show up historically in such a massive data set. But it doesn’t, because gold has obviously never been a yield play!
On average during the exact spans of all 11 of the Fed’s rate-hike cycles of the modern era, gold rallied 26.9% higher! That’s a serious gain during events that are supposed to slaughter gold. A similar gold upleg off its latest secular low driven by Fed-rate-hike fears would carry this metal all the way back up near $1336. If I was a futures speculator heavily short gold with extreme leverage, this would terrify me.
Digging deeper, the hard historical data proves Fed-rate-hike cycles are even more bullish for gold. The majority 6 of these 11 cycles have seen gold gains averaging a staggering 61.0%! Gold is more likely to rally big during a Fed-rate-hike cycle than fall, contrary to speculators’ self-fueled delusion today. And a merely similar gain off gold’s latest secular low in the coming cycle would catapult it vastly higher near $1695.
But in the immortal words of legendary pitchman Billy Mays, but wait there’s more! In the other 5 Fed-rate-hike cycles where gold lost ground, its average loss was just 13.9%. Gold’s wins when the Fed is hiking rates overpowered its losses in a very asymmetrical commanding manner. There is simply no way the case can be made historically that Fed-rate-hike cycles are exceedingly bearish for zero-yielding gold.
It blows my mind that American futures speculators refuse to see this hard truth. These guys are making super-risky leveraged downside bets on gold on a totally-false premise! Their record gold-futures short selling since the FOMC’s hawkish surprise in late October is happening at extreme leverage of up to 28x, vastly greater than the decades-old legal limit in the stock markets of 2x. The price for being wrong is catastrophic.
At 28x leverage, a mere 3.6% gold rally would wipe out 100% of the capital risked by speculators in their recent extreme record shorting binge. Anything beyond that would ignite a ruinous wave of margin calls where they would lose far more money than originally bet. With so much capital at stake that could be wiped out in a matter of hours if they are wrong and gold rallies, you’d think they could study some history.
This basic research took me less than a day, not much time for futures speculators to invest to protect their hard-earned wealth. And even if they aren’t willing to look back 45 years, how about just the last Fed-rate-hike cycle. That ran between June 2004 to June 2006, and saw the Fed more than quintuple its federal-funds rate to 5.25% through 17 consecutive hikes totaling 425 basis points. Did that slay gold?
Not so you’d notice. Instead of spiraling into oblivion as speculators universally assume will happen in this next rate-hike cycle, gold powered 49.6% higher over that exact span! A similar gain off gold’s latest secular low would blast it up to $1575. Clearly Fed-rate-hike cycles in real-world history are nothing like the insurmountable nemesis for gold that is wrongly assumed today. What a steaming pile of crap.
With Fed-rate-hike cycles actually overwhelmingly bullish for gold historically contrary to the groupthink delusion today, let’s examine the factors separating gold’s wins from losses. It turns out there are two dominant ones, the gold levels where it enters Fed-rate-hike cycles and the pace of their actual FFR hiking. Gold performs best when it enters the rate-hike realm near lows and those hikes are gradual.
If you carefully examine the 5 rate-hike cycles in these charts where gold lost ground, in 4 of those the gold price was up near major secular highs when those cycles began. Like anything in the markets, gold can only be driven to lofty heights if investors like it and have already deployed heavily into it. This leaves gold overbought and technically vulnerable, overriding any other influencing factors including rate hikes.
Obviously gold isn’t entering this coming Fed-rate-hike cycle near major secular highs, just the opposite is true. Just last week, the extreme gold-futures selling by American speculators battered gold to a major new 6.1-year secular low. Investors are radically underinvested in this essential portfolio diversifier now, and it is universally despised. That means there is huge room for capital to return as the Fed hikes rates.
The historical record shown in these charts proves that gold’s biggest gains during Fed-rate-hike cycles occur when it enters them near major secular lows. So leading into the FOMC’s likely initial rate hike next week, we have the best-possible gold-price setup. With gold so darned low and speculators’ futures short selling so epically high, a sell-the-rumor buy-the-fact scenario on the Fed’s hike is highly likely.
The second major driver of gold’s performance during Fed-rate-hike cycles is the pace of those rate hikes. In the 6 rate-hike cycles since 1971 that saw average gold gains of 61.0%, the average federal-funds-rate-target increase per hike and per month of these rate-hike cycles were only 35 basis points and 24bp. Investment capital flowed into gold most readily when the Fed was the most gradual and measured.
In contrast, during the other 5 rate-hike cycles that saw gold lose an average of 13.9%, the average FFR increase per hike and month were radically higher at 110bp and 141bp! During times of extreme market stress, the Fed tends to panic and get aggressive. The resulting dislocations including massive bond losses tend to frighten investors into cash instead of gold. This pace-of-hikes gold link was very pronounced.
Overall the 11 Fed-rate-hike cycles since 1971 saw average per-hike and per-month FFR increases of 69bp and 77bp. So gold thrived when the hiking pace was well below this average, and slumped when it was well above. And by this historical standard, the Fed’s next rate-hike cycle couldn’t possibly look any more bullish for gold. The uber-dovish Yellen Fed has all but promised it will be the most gradual ever.
Just last week, Janet Yellen gave a speech in Washington where she said the FOMC is not planning to use its normal rate-hike-cycle strategy of hiking at every meeting. That’s what it did in its last one in the mid-2000s, 17 consecutive hikes in 17 consecutive FOMC meetings. Yellen drove home her gradualist approach on the hiking pace saying, “This may turn out to be a very different cycle than past cycles.”
Federal-funds futures traders, the best in the world at handicapping the vagaries of central-bank action, currently believe the FOMC will hike next week and 2 to 4 times in 2016. And they expect the hikes to be just 25 basis points each. So we are looking at 9 FOMC meetings including next week’s over 12 months, and a total FFR increase between 75bp to 125bp. We can average this to a 100bp midpoint for illustration.
If the Fed hikes by 100bp over the next year, which most traders think is far too aggressive to happen, we are looking at a pace of hikes averaging just 11bp per FOMC meeting or 8bp per month. That would easily be the slowest Fed-rate-hike-cycle pace of modern times, and almost certainly the entire 102-year history of the Federal Reserve. Remember the more gradual the rate hikes, the more gold tends to power higher!
So with gold near major secular lows heading into this imminent Fed-rate-hike cycle, and that cycle itself likely to be the most gradual ever witnessed by far, gold is overwhelmingly likely to power dramatically higher as the Fed hikes rates. That’s what gold’s done in rising-rate environments historically, so that’s what gold is almost certain to do again regardless of American futures speculators’ delusions on this.
And that leads to a final important question. Why do investors return to zero-yielding gold when rates are rising? The answer is simple. Rising rates are far more damaging to overvalued stock and bond markets than gold. Rising rates create direct losses on existing bonds’ principal as those outstanding bonds are sold in the marketplace to reflect higher prevailing yields. So some bond investors flee to gold.
So do stock investors as rising rates hit overvalued stock markets on multiple fronts. They increase debt-service costs throughout the economy, leaving less money to spend which erodes corporate sales. This forces earnings lower, increasing valuations. Higher borrowing costs also curtail the debt-financed corporate stock buybacks that boost earnings per share, which have been incredibly high during the ZIRP years.
Gold is really unique in that it is a true alternative investment that moves contrary to stock markets. So it tends to fare the best, enjoy relentlessly-growing investment demand, when stock markets are suffering. And boy do Fed-rate-hike cycles wreak havoc on stocks, especially when they enter the cycles up near secular highs at overvalued levels like today. So this next Fed-rate-hike cycle looks super-bullish for gold prices.
Investors can position for this coming Fed-rate-hike-cycle trend through traditional physical gold bullion itself, or via the flagship GLD SPDR Gold Shares gold ETF. But the greatest way to really multiply wealth as gold inevitably returns to favor is in the left-for-dead shares of its elite miners. They are now trading down at fundamentally-absurd levels relative to their existing profits, which will soar as gold powers higher.
Gold stocks are very likely to be the best-performing sector next year by far, and you are going to kick yourself 6 months from now if you ignored this incredible opportunity to buy them near extreme 13-year secular lows. We’ve been aggressively buying and recommending the elite gold and silver stocks at Zeal in recent months. It’s not too late to join us and get deployed before the Fed’s rate hikes get underway.
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The bottom line is contrary to American futures speculators’ fervent belief, gold thrives during Fed-rate-hike cycles historically. Rising rates are very damaging to conventional stocks and bonds, which leads investors to return to counter-cyclical gold. The lower gold’s price levels entering Fed-rate-hike cycles, and the more gradual their hiking pace is, the better gold performs as the Fed forces interest rates higher.
History overwhelmingly proves this, with gold rallying in the majority of Fed-rate-hike cycles to enjoy very large average gains. And given the radical underinvestment in gold today and record extreme gold-futures shorting by speculators on the false premise that Fed rates hikes are gold’s nemesis, gold’s upleg in this next Fed-rate-hike cycle should prove exceptionally large. Frenzied short covering will initially fuel it.
Adam Hamilton, CPA
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