Investment Update: The impact of monetary policy on gold

The upcoming Federal Reserve Open Markets Committee (FOMC) meeting on 20 March is expected to confirm market expectations that the Federal Reserve (Fed) will remain on hold for the rest of the year. This, in turn, will likely influence gold’s performance. Our historical analysis shows that when the Fed has shifted from a tightening to a neutral stance, gold prices have increased, even if this effect has not always been immediate. In our view, the combination of rangebound US interest rates, a slowdown in the appreciation of the US dollar and continued market risks will continue to make gold attractive to investors.

Gold drivers in 2019

In our 2019 Outlook, we cited “monetary policy and the direction of the US dollar” as a key trend to watch this year. With this, we believe that the 20 March FOMC meeting, which will include the Fed’s projections report, will provide more clarity about their monetary policy expectations which, in turn, will offer further guidance about gold’s performance this year. As it stands, current bond prices reflected by the market, which tend to accurately include interim cues from the Fed, are signaling that the Fed will most likely be on hold during 2019 – and has a chance of a cut (15%) for the first time in several years (Chart 1).

Chart 1: Market expectations point towards a shift in monetary policy from tightening to neutral

Fed fund rate and market expectations*

Chart 1: Market expectations point towards a shift in monetary policy from tightening to neutral

Fed fund rate and market expectations*

Sources: Bloomberg, World Gold Council; Disclaimer

*As of 28 February 2019.

 

Rates have become more influential

Drivers of gold fall into four categories and the interactions between these categories determine gold’s short- and long-term performance (Focus 1). 

During 2018, the performance of gold was largely influenced by the direction of the US dollar, but interest rates, in conjunction with market uncertainty, have once again taken a front seat (Chart 2). Why is this?

Chart 2: A shift in monetary policy expectations has influenced gold’s performance in recent months

Contribution to gold returns from movements in the US dollar, changes in interest rates, and other factors*

Chart 2: A shift in monetary policy expectations has influenced gold’s performance in recent months

Contribution to gold returns from movements in the US dollar, changes in interest rates, and other factors*

Sources: Bloomberg, World Gold Council; Disclaimer

*Based on a proprietary attribution model developed by the World Gold Council using the four drivers of gold described in Focus 1. “Other” include economic expansion, uncertainty, and momentum. For more details, see Goldhub.

Our previous research highlighted the fact that interest rates have greater impact on asset price performance (including gold) when there is a shift in policy stance (e.g. from neutral to tightening or vice versa),1 and our analysis of gold’s performance in January suggests that, indeed, expectations of interest rates are starting to play a more influential role than they did in 2018.

Implications for gold

The relevant question for gold investors is, if monetary policy is about to shift from tightening (higher rates) to neutral (steady rates), should this be positive for gold?

As such, we look at the historical performance of gold and major assets during past hiking cycles as well as during periods when policy has transitioned from tightening to neutral and, eventually, easing. 

Gold price effects after a cut

The immediate average effects (one to three months) of a transition in policy from tightening to neutral on gold are not clear cut. Reasons for this could be:

  • Uncertainty over whether hiking might resume
  • Falling inflation or lower risk of rising inflation – generally seen as bad for gold
  • Shift in investor allocation to safe fixed income (government bonds, cash) from riskier assets, in lieu of allocations to gold
  • An uncertain dollar trajectory: rates argument for dollar likely weaker, but safe-haven argument building.

Not all cycles are the same

Not all cycles show such parallels. The current cycle shares more similarities with the last two: 1999-2000 and 2004-2007, although those periods did experience rate cuts. This suggests potential for rising gold prices in the intermediate term.

  • Rates had been rising without pause for at least 12 months in both cycles
  • The yield curve was flat or inverted in both cycles
  • Retail sales were falling in both cycles
  • Credit conditions were worsening (2006-2007)
  • Risk assets' valuations were unusually extended (2000)
  • The oil price had peaked (2000)

Gold tends to rally in the intermediate term

Based on the most recent cycles, our analysis indicates that gold does perform better in a post-tightening cycle, but the period over which this occurs varies (Table 1). For example, gold rose 3.6% in 2001; 12 months after the Fed stopped raising rates. But it rose 7% only one month after the transition in 2007, a trend that continued as it was 19% higher 12 months after the Fed’s last hike. 

Gold generally outperformed stocks and the broad commodities complex during these same periods. It also outperformed US government and corporate bonds in the more recent post-tightening cycle – coinciding with the 2008-2009 financial crisis – and this was most likely as a result of more widespread systemic risks (Table 2).

Table 1: Gold performance during tightening and post-tightening cycles*

Gold 1999-2001 2004-2007 2015-present
Annualised tightening cycle return 2.2% 20.8% 7.2%
Post-tightening cycle returns      
1m return -0.6% 7.0%  
3m return -3.4% 13.1%  
12m return 3.6% 18.8%  

*Based on the performance of the gold spot price.
1999 – 2001 represents 30 June 1999 – 2 January 2001
2004 – 2007 represents 30 June 2004 – 17 September 2007
2015 – Present represents 16 December 2015 – 27 February 2019

Source: Bloomberg, World Gold Council
 

What does this all mean?

While no clear evidence points to an immediate positive impact on the price of gold after the Fed pauses, historical analysis suggests that gold eventually reacts positively as the pause cycle extends and/or the Fed eases monetary policy.

Historical post-tightening periods have shown an eventual strong gold performance, counterbalancing the performance of risk assets such as stocks or commodities, and complementing – sometimes even outperforming – assets such as Treasuries and corporate bonds.

Adding the effect of rates to other key gold drivers 

Outside the US, the ECB surprised markets in recent months by extending its asset purchase programme; yet unlike US Treasuries, the bond markets in Europe and the UK are still pricing a positive, if small, chance of a rate hike this year. This, combined with continued uncertainty surrounding trade negotiations between China and the US, may likely slow down the appreciation of the US dollar. 

If, indeed, the Fed were to signal a more dovish stance and the US dollar remains rangebound, this will likely remove some of the strong headwinds that gold faced in 2018.

Furthermore, there are additional potential risks to global financial markets, including:

  • The long duration of current recovery – seen as a potential sign of economic exhaustion
  • Flattening and inversions of key yield curves with the lack of investment driven growth – indicating signs of possible recessions
  • Continued lofty valuation of stock markets at levels last seen during the dotcom bubble on a CAPE ratio – highlighting potential volatility bouts
  • Deteriorating credit conditions at both the consumer and corporate level
  • Continued uncertainty surrounding Brexit timing and implications. 

Combined, these factors may support investment demand by providing an entry point for investors looking to add gold to their portfolios as a source of returns, diversification, liquidity and portfolio impact.2

Table 2: Major assets performance during tightening and post-tightening cycles*

US stocks 1999-2001 2004-2007 2015-present
Annualised tightening cycle return -2.2% 10.6% 12.7%
Post-tightening cycle returns      
1m return 5.3% 4.4%  
3m return -11.8% 1.1%  
12m return -7.4% -16.5%  
Commodities 1999-2001 2004-2007 2015-present
Annualised tightening cycle return 31.0% 10.6% 7.2%
Post-tightening cycle returns      
1m return 3.9% 3.6%  
3m return -2.5% 5.9%  
12m return -15.0% 0.9%  
US government bonds 1999-2001 2004-2007 2015-present
Annualised tightening cycle return 10.0% 4.7% 1.5%
Post-tightening cycle returns      
1m return -0.1% 0.4%  
3m return 1.8% 3.1%  
12m return 5.0% 10.6%  
US corporate bonds 1999-2001 2004-2007 2015-present
Annualised tightening cycle return 7.3% 4.4% 4.0%
Post-tightening cycle returns      
1m return 1.9% 1.6%  
3m return 3.6% 1.6%  
12m return 9.0% -2.9%  

*Performance based on the S&P 500 Index, the Bloomberg Commodity index, the Bloomberg Barclays US Treasury Total Return Index, and the Bloomberg Barclays US Corporates Total Return.

1999 – 2001 represents 30 June 1999 – 2 January 2001

2004 – 2007 represents 30 June 2004 – 17 September 2007

2015 – Present represents 16 December 2015 – 27 February 2019

Source: Bloomberg, World Gold Council

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