Gold prices have gone up a lot, but the metal is still a cheap hedge against tail risk, even in an environment of rising interest rates, which many market participants incorrectly view as a necessarily negative impact on gold prices.
This prevailing view that rising interest rates are bad for gold prices only holds true when the Federal Reserve Bank remains ahead of the curve. When the Fed has delayed raising rates in line with inflation, gold prices have outperformed. The Fed is now repeating its policy error, and that’s good news for gold investors.
Indeed, the Fed has not been consistent in its policy message, continually alternating between hawkish and dovish leanings. In December, the Fed was expecting four rate hikes in 2016, but we are now on track for two. The Fed still maintains that it has more policy tools to overshoot on inflation than to undershoot. But the data suggests the Fed should be accelerating rate hikes. With core inflation hovering around 2.2% and unemployment at a historically low level, inflation is likely to increase if the Fed keeps the current stance on rates. The ensuing confusion runs counter to the mandate of price stabilization and maximizing employment, and it keeps the Fed steadily behind the curve.
For the rest of 2016, this policy error by the Fed will probably prove very costly in terms of volatility across asset classes, including some commodities. But it is important to separate gold from industrial metals more exposed to the impact of basic supply-demand dynamics. Compared to platinum and palladium, for example, gold does not have significant industrial applications. Serving more as a defensive asset, gold outperforms when uncertainty increases and cyclical markets turn bearish.