Interest rate disconnect
October 25, 2004
By now the relationship between the price of gold
and the US dollar exchange rate is well established and old hat.
Yet it remains very important: the dollar will continue to drive
the gold price for the foreseeable future, until rampant speculation
takes over and we find ourselves in a rip-roaring, emotionally charged,
gold bull market. That will be then. For now we have to concern
ourselves with the US dollar and its impact on the gold price.
If the US dollar exchange rate is driving the gold
price, what is driving the US dollar? The answer is interest rates.
When interest rates rise, the return on fixed income
securities, such as bonds, increases. Higher investment returns
attract foreign capital and foreign demand for US investments creates
demand for dollars. The increase in foreign demand for dollars (to
buy US securities) raises the US dollar-exchange rate. And, of course,
a stronger dollar means a lower gold price.
So, we know that the gold price depends on the dollar
and the dollar depends on interest rates. Therefore, the gold price
is indirectly responding to changes in US interest rates.
The following charts will illustrate these points.
The first chart shows the US dollar gold price versus
an index of the US dollar exchange rate against the currencies of
the G10 nations. Note that I have inverted the G10 Index so that
the dollar is actually getting weaker as the index moves higher.
It’s clear that the gold price is rising as the dollar is
Next, let’s look at the same dollar index compared to US interest
rates. I have chosen the yield on constant maturity ten-year US
Treasury Bonds as a proxy for interest rates and this time the G10
Index is not inverted, so a decline in the G10 Index reflects a
decline in the dollar. Obviously the dollar has been falling as
interest rates declined.
If we now compare the US dollar gold price to US interest
rates (same yield on ten-year constant maturity bonds) then we can
clearly see the inverse relationship between the gold price and
US interest rates: as interest rates decline, gold prices go up.
In the following chart the interest rate curve has been inverted
to show the relationship better, so an increase in the red line
is actually a decline in interest rates.
Okay, so the gold price is driven by the dollar and
the dollar is driven by interest rates making the gold price a function
of interest rates. When interest rates decline, the dollar falls
and the gold price rises.
So far everything is working as expected: the economy
is getting weaker, interest rates are falling, the dollar is falling
and the gold price is rising. However, for most of the year I’ve
been saying that for the gold price to sustain a meaningful rally
we need to see the dollar fall in conjunction with higher interest
rates; in other words we need to see the gold price rise with rising
interest rates, and that is contrary to what is currently happening.
For the gold price to rise along with rising interest
rates it first needs to disconnect from the influence of interest
rate changes, and that means the dollar has to disconnect from the
interest rate. That is both possible and probable, as I will explain
in a minute.
In the meantime the gold price remains vulnerable
to an increase in US interest rates.
If interest rates increase prior to the disconnect
it will cause the dollar to rally and the gold price to fall. You
may recall that the Wall Street Journal reported last week that
bond investors are betting on just that: an increase in interest
rates, which means the aforementioned risk is not to be ignored.
One possible reason bond investors are betting on
higher interest rates is the US budget deficit. The budget deficit
has to be financed by issuing US Treasury bonds and an increase
in bond issuances should cause bond prices to fall and interest
rates to rise, leading to a decline in the gold price.
However, the growing budget deficit is a major problem
for the United States. It, and the trade deficit, will ultimately
lead to the disconnect between the dollar-exchange rate and interest
rates. Because the budget deficit has to be financed by issuing
Treasury bonds it will put upward pressure on interest rates. This
occurs because issuing bonds, especially in the amount required
to finance the budget deficit, will put downward pressure on bond
prices and interest rates are nothing more than the yield in debt
instruments, such as bonds. So when bond prices decline, as they
will because of the budget deficit, interest rates will rise.
Financing the budget deficit is a long-term problem
for the US and it cannot be avoided given the government’s
current policies, which are unlikely to change much regardless of
who wins the election. Because of this I believe that interest rates
in the US will increase irrespective of whether the economy can
cope with higher rates or not. When interest rates start to rise
the dollar could potentially rally driving the gold price down.
However, rising interest rates will wreak havoc on
the fragile US economy. As the economy weakens it will become more
and more difficult to attract sufficient foreign capital investment
to offset the trade deficit. Once that happens the US dollar will
fall and, no, I don’t think China, Japan and the United Kingdom
are going to support the dollar forever.
It is this combination of rising interest rates, from
bond issuances to finance the budget deficit, and a falling dollar
resulting from continued weakness in the US economy accompanied
by declining foreign investment that will lead to a disconnect between
the US dollar and interest rates. And that will set up the next
major increase in the gold price.
Under this scenario the dollar will fall in conjunction
with rising interest rates; the opposite of what is happening now.
Until then, the dollar remains positively correlated to interest
rates and hence the gold price remains negatively correlated to
interest rates, and that is something that gold investors should
bear in mind.
Paul van Eeden
Paul van Eeden works primarily to find investments for his
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