How Fed Rate Hikes Affect Gold: What You Need to Know?

June 14, 2022
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The US Federal Reserve has long been a source of uncertainty for markets, rattling investors with unannounced interest rate hikes and equally surprising moves in the opposite direction.

Those policy shifts can have a significant impact on the price of gold. At the same time, a central bank's policy of raising short-term interest rates means that the lending costs involved in borrowing money will be higher.

It signals that the bank sees too much money flowing through financial markets and a rising possible inflationary risk. It makes gold a good hedge against rising inflation and a relatively safe haven in times of geopolitical and financial uncertainty.

What is a Federal Reserve Rate?

The Fed is the central bank of the United States. It sets monetary policy for the country by setting the federal funds rate, which commercial banks lend to each other over night.

It is the most important interest rate for markets because it affects nearly every financial product. If the Fed raises the rate, it signals that it sees too much money flowing through financial markets, leading to inflation.

On the other hand, a lower rate signals that there is too little money flowing through markets and that economic activity could slow down. As a result, markets generally follow the Fed's guidance on when to expect the next rate hike by betting on the direction of the federal funds rate.

How Often Does the Fed Raise Interest Rates?

Since March 2020, when the world economy was shut down to halt the spread of theCovid-19 pandemic, the federal funds rate has been zero.

The Federal Open Market Committee establishes the target interest rate for commercial banks to buy and lend excess reserves to one another overnight. It's frequently regarded as a reference point that impacts short-term interest rates on anything from car loans to credit cards.

The FOMC now intends to raise interest rates at each of its six scheduled sessions this year. If those increases are quarter-point increases, the rate may reach1.75 percent to 2 percent by the end of 2022, the highest level since 2019.

How Does a Fed Rate Hike Affect Gold?

Gold and interest rates have historically had a negative correlation. It is not certain, but the gold price normally rises when interest rates fall and falls when interest rates rise.

For instance, during the gold bull market of the 2000s, interest rates fell dramatically as gold prices increased. However, there is still no evidence of a clear, consistent association between increasing rates and falling gold prices or lowering rates and climbing gold prices because gold prices topped far ahead of the most dramatic drop in interest rates.

Rising interest rates make equities, government bonds, and other investments more appealing to investors.

Conversely, lower interest rates make these alternative assets less tempting, causing investors to gravitate toward gold, raising demand and price. For this reason ,gold is seen as a safe investment in times of financial distress.

When the Fed raises short-term interest rates, borrowing money is more expensive. That pushes up the price of goods and services, so the Fed rate hike is also often referred to as a "wage-push inflation" event.

It's important to note that the Fed's policy of raising rates is only one of the reasons why gold prices go up and down. Gold's price is affected by interest rates because it's often used as an investment. People buy it to hedge against inflation, as well as to diversify their holdings across different assets.

As interest rates rise, holding fewer gold bars to cover the same amount of risk makes sense. In other words, investors see gold as a good hedge against rising inflation and a relatively safe haven in times of geopolitical and financial uncertainty.

What does the theory say?

The Fed's hawkish stance should mean that investors will demand more gold as a hedge against rising inflation.

However, his doesn't mean that gold will go up in price at every Fed rate hike. The gold price is swayed by many other factors, including geopolitical tensions, economic growth, and even election results.

In the end, the price of gold is unrelated to interest rates. In the long term, it results from supply and demand, much like other fundamental commodities. While increases in supply can cause the price of gold to fall, demand is ultimately the more powerful component of the two.

Because it takes ten years or more for a found gold resource to be transformed into a producing mine, the amount of gold supply fluctuates slowly.

Rising and higher interest rates may be positive for gold prices, even though they are often bearish for equities.

Because gold is traded in dollars, some speculators believe the greenback is a significant driver of gold prices. When the value of the dollar dips, buyers may buy more gold for the same amount of money, resulting in greater demand and higher gold prices.

How to buy gold to hedge against rising inflation?

If you want to hedge against rising inflation and invest in gold, you'll need to buy the precious physical metal. However, buying gold isn't as straight forward as it sounds.

There are two basic ways to do it: an Exchange-Traded Fund (ETF) or through a gold broker.

An ETF is an investment fund that holds many different assets. The most popular ETF holds US Treasury. An ETF means that you don't need to own gold to take advantage of it to hedge against rising inflation. However, an ETF will cost you extra money because it will charge you a fee whenever the price of gold rises.

A gold broker will allow you to buy physical gold at the current market price. You'll also be able to sell it at a later date. This is preferable because you don't incur a fee to hold the gold.

Final thoughts

While higher interest rates may weaken the US dollar, causing gold prices to fall, the true drivers of gold prices are equities prices and volatility and general supply and demand.

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