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Will a Fed Rate Rise Hit Gold Prices?

Higher interest rates may not help the Dollar...

THERE IS A WIDESPREAD BELIEF that if interest rates rise, the exchange rate rises, writes Julian Phillips at GoldForecaster.com.

But is it always the case? Well, you can be sure that if there was still a Spanish Peseta or Greek Drachma and they were paying the sort of interest rates their sovereign bonds were paying now, these currencies would still be falling.

Many feel that if interest rates rise, Gold Prices would automatically fall. But is that going to be true? There’s a great deal more involved to this story than just interest rates...

In an economy like China's, borrowers tend to be businesses enjoying the remarkable growth rates of around 10%. Their businesses in general are thriving and income is either steady or growing, with the potential to grow more, or easily pay down debt. 

If you throw 7% inflation at them on certain items, their ability to absorb those costs is enormous. These items may include oil and food, which do absorb a large portion of discretionary spending, but are accepted as one of life’s burdens that we all must endure. 

Usually, Chinese businesses can pass on higher costs to their customers without driving them away. In such an environment, interest rate rises then have the desired effect of tempering growth without stifling it. Overheating, at the risky end of the market, is restrained.

Along with a remarkable cooperation with government economic objectives, higher interest rates have the desired effect of keeping the economy growing without excessive strains in one part or the other. 

It is very difficult, by contrast, for an economy in recession to absorb food and energy price inflation. Traditional economics would have central banks attempt to ensure that such inflation does not flow into other areas. But central banks can only use interest rates to try to do this. 

Interest rates are a sledgehammer – and a misdirected sledgehammer at that. In so many cases, higher interest rates merely impose yet another burden on businesses that are struggling to survive, and erode profitability. 

The effect of interest rate rises in this climate is to curtail business activity even more. At its worst, this kind of policy can eventually precipitate a depression. By damaging already weak consumer confidence, its impact is that much greater – and that much more difficult to recover from. If confidence is already undermined, then such further cost pressures send it spiraling downward. 

Now let's take a situation not quite as drastic as that above. There is little to no economic growth and the economy suffers from the impact of food and energy inflation. Energy inflation is imported, so there is usually no way to restrain such price increases. Food inflation in economies that are not self-sufficient has the same effect. 

Now, along the lines of traditional economics, inflation is the one factor that prompts rate increases. Whether it is a one-off spike, or a persistent rising of the oil price does matter, but these days there appears to be no respite from these, which now drive the price of oil to $113 per barrel. An interest rate increase, when it comes, becomes an additional drain of income, thus adding to the burden of a business that is struggling to survive and doesn’t see any economic relief. 

The result is that the business now begins to suffer. It targets cost cutting, which in turn ensures the overall economy of the nation either continues to stagnate or declines into recession or worse. 

The theory that is usually accepted is that if you raise interest rates you raise the value of a currency internationally. This is true where an economy is growing in a sustainable way, provided exchange rates are not managed by the central bank or government. 

The carry trade has the function of borrowing money from a low interest rate nation and placing it on deposit in a high interest rate paying nation, so placing downward pressure on one exchange rate and upward pressure on the recipient currency. It is another source of gain if the prospects for the currency where the funds are borrowed are poor and it is declining anyway. This allows interest gains to be enlarged by a capital gain on the exchange rate.

Where interest rates are rising but inflation is higher there exists a negative real interest rate. This will lead to an exchange rate decline. Where the decline is due to economic fundamentals, then rising or high interest rates may well not look attractive to outside lenders. This negates any benefits from interest rate hikes.

Take, for instance, an individual who is over-borrowed and his business declines to the point where he cannot service his loans. The bank would usually call in those loans and if unable to, will sell the client’s assets in an attempt to cover the debt. 

If that man were to approach another bank for more loans with which to delay sequestration it may be that he gets the loan, but to what impact on his balance sheet? He will, of course be forced to pay a higher interest rate. This will ensure the likelihood of repayment is reduced. 

The higher interest rate will by no means raise his credibility in the market place. Greece, Ireland, Portugal and Spain have moved into that category. The US debt situation has recently been likened to Greece’s. So to attract more foreign capital, would higher interest rates add credibility to the US debt position? In that case no.

If the US were to attempt to ensure zero real interest rate levels by raising interest rates to that of internal inflation – including food and energy inflation – the impact would not be to make the Dollar more attractive, but to at best stave off the speed at which the Dollar is falling in foreign exchange markets. 

State and federal borrowing would then have to offer higher interest rates. This would hammer the bond market and frighten off foreign lenders as well as cause the economy to move into stagflation. 

Certainly, no such rate hikes will take place until the US economy is able to maintain growth in the face of such rises. This may well take some time longer.

The European Central Bank (ECB) has let it be known that they will impose three interest rate hikes in 2011 in an attempt to rein in inflation, primarily from food and energy. The ECB is clearly of the opinion that the stronger Eurozone economies are able to bear these rises. 

Economic activity is concentrated in the stronger EU economies. While the ECB is aware that such interest rate hikes will hurt its southern members, their relevance to the overall EU economies is not of significance. They are trading on the belief that the woes of these nations will not undermine confidence in the Euro itself. In fact, the joy of having weak members in the Eurozone is that they help to keep the Euro exchange rate down and the stronger members competitive internationally.

We feel they may have miscalculated in that the confidence in the Euro may well prove mercurial should any more members need financial assistance to meet their debt obligations. Their inability so far to finalize the composition and strategy of the bailout fund may well lead to them being overextended on their balance sheet. Should the Eurozone subsequently slip into stagnation, they will be seen to be overextended.

Again it comes back to confidence and the waning of instability. If US interest rates move into real positive territory on the back of a sustainable recovery then the Dollar will offer value. If the recovery has not gained real traction and rising interest rates still leave them negative real rates, then the Dollar will not offer value. In the former case US gold investors may well liquidate their holdings to some extent. In the latter case there is little reason to sell Gold Bullion holdings.

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JULIAN PHILLIPS – one half of the highly respected team at GoldForecaster.com – began his career in the financial markets back in 1970, when he left the British Army after serving as an Officer in the Light Infantry in Malaya, Mauritius, and Belfast.

First he worked in Timber Management and then joined the London Stock Exchange, qualifying as a member and specializing from the beginning in currencies, gold and the "Dollar Premium". On moving to South Africa, Julian was appointed a macro-economist for the Electricity Supply Commission – guiding currency decisions on the multi-billion foreign Loan Portfolio – before joining Chase Manhattan and the UK Merchant Bank, Hill Samuel, in Johannesburg.

There he specialized in gold, before moving to Capetown, where he established the Fund Management department of the Board of Executors. Julian returned to the "Gold World" over two years ago, contributing his exceptional experience and insights to Global Watch: The Gold Forecaster.

Legal Notice/Disclaimer: This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment. Gold Forecaster/Julian D.W. Phillips have based this document on information obtained from sources they believe to be reliable but which it has not independently verified; they make no guarantee, representation or warranty and accepts no responsibility or liability as to its accuracy or completeness. Expressions of opinion are those of Gold Forecaster/Julian D.W. Phillips only and are subject to change without notice. They assume no warranty, liability or guarantee for the current relevance, correctness or completeness of any information provided within this report and will not be held liable for the consequence of reliance upon any opinion or statement contained herein or any omission. Furthermore, they assume no liability for any direct or indirect loss or damage or, in particular, for lost profit, which you may incur as a result of the use and existence of the information, provided within this report.

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