Many investors assume that an increased interest rate affects gold prices negatively, but there is little to no evidence that supports that. In fact, history shows that increases in the interest rate may actually boost gold prices.
The popular belief
Currently, the Federal Reserve is slowly normalizing interest rates, and according to some investors and market analysts it will result in lower gold prices. Their rationale is that rising interest rates—which make bonds and other fixed-income investments more attractive—will lead to increased investments in higher-yielding assets such as money market mutual funds and bonds. This, in turn, directs investments away from gold, which offers no yield.
What history tells us
A long-term review of the developments of interest rates and gold prices reveals that no such negative correlation exists. In fact, the correlation over the past 50 years is 20%, which is considered to be statistically insignificant.
In the 1970s, gold reached its all-time high, when adjusted to inflation, and this took place while interest rates were high and increasing. Starting in 1971, short-term interest rates were at their lowest at 3.5% but went up to a stunning 16% in 1980. Meanwhile, gold price exploded and went from $50/ounce to $850/ounce! What we saw in this period was a positive
correlation between gold price and interest rates.
In the 1980s, gold prices dropped along with steadily declining interest rates, while, in the 2000s, gold prices rose while interest rates decreased significantly. However, it does not provide any significant evidence that interest rates and gold correlate—gold prices peaked well before the interest rates plummeted.
Recently we saw that the gold price is correcting downward while interest rates have remained just above zero. If we followed the popular belief, gold prices should have continued to blossom after the 2008 financial crisis, which it did, but as the stock market and real estate markets heated up, commodities turned lower, inspite of extremely low interest rates. Between 2004 and 2006, gold increased in value by a whopping 49% while the federal funds rate rose to 5%.
A function of supply and demand
In the long run, like most commodities, gold price movement is a function of supply and demand, not of interest rates. For precious metals, demand is the key driving force here because supply changes very slowly—typically, it takes at least ten years for a new gold deposit to become a producing mine.
When increasing interest rates favor fixed income investments, it is the stock market, not gold, that suffers. In most cases, investors divert investments from stocks into bonds when interest rates rise. Companies also face higher financing expenses, which typically directly impacts net profit margins negatively—a fact that further emphasizes higher interest rates result in stock devaluations.
The strength of gold
When stock market indexes boom, they are highly susceptible to severe downwards corrections. When such correction happens, one of the first assets investors go for is gold. For instance, during 1973 and 1974, when interest rates rose, and the S&P500 Index was almost cut in half, gold prices went up by more then 150%. The same thing happened after the 2008 financial crisis, when gold prices went up by 300% over 3 years.
Given the historical data, it is more likely that rising interest rates impact stock prices negatively while boosting gold prices.