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.

By contrast, platinum, palladium and silver do better when economic growth drives industrial demand. In March we saw a cyclical recovery after a very volatile January and February, when equity markets plummeted and volatility spiked across a number of asset classes. At that time, gold performed well. As the recovery set in, gold sold off a bit while the cyclical metals – not only platinum, palladium and silver, but even copper and nickel – performed well.

Many strategists anticipate continued volatility in the second quarter and beyond. The United Kingdom’s decision to stay in or exit the European Union (EU) could be destabilizing. The very unorthodox U.S. presidential election could have unpredictable ripple effects. Global geopolitical risk, including issues in the Middle East and the refugee migrations around Europe, can also contribute to spikes in volatility. A number of shocks to global markets would increase the appeal of an asset like gold. At the same time, we know based on official data that central banks are accumulating gold. Unofficially, they may be accumulating even more. The motivation is probably to normalize their gold holdings. The central banks in Russia and China hold significantly less gold relative to other foreign exchange reserves than their counterparts elsewhere in the world. China and Russia probably want to diversify their holdings in line with other markets.

In contrast to a few years ago, the Chinese central bank now reports its gold holdings on a monthly basis. We have a bit more clarity now on China’s game plan. The country is accumulating gold, but as a percent of the balance sheet, gold holdings are still quite small. The increases, while significant, are building on a small base. The real risk for this market is the under-reporting of gold holdings. In the past few years there has been a discrepancy between the gold coming into the market and the gold consumed in the jewelry market.

Given the powerful drivers of demand, the risk-reward profile of gold and other precious metals compares favorably to other commodity categories, including agricultural products, which face challenging supply-demand dynamics. True, mining stocks have outperformed precious metals so far this year, but that is mainly because miners had underperformed for so long. In the final analysis, as long as the Fed continues to delay the inevitable rate hikes, gold looks attractive, both on a relative and absolute basis.