Lear Capital: Will Rising Interest Rates Skyrocket the Gold Price?

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The great Gold Bull Market of the 20th Century is said to have started in 1972, just after Richard Nixon announced on August 15, 1971, he was taking the United States off the Gold Standard. At that time Nixon realized foreign countries were hoarding more gold and silver-backed currency than could actually be redeemed by the precious metal's reserves we held.

Once again, gold could be traded freely allowing the market to determine its fair value. At the outset, gold prices were fixed at $42.22 per ounce but by February 1972, moved to $48.26 as trading began. From there a steady rise would ensue to levels 17 times greater than this initial trading price. On January 21, 1980, the gold spot price reached $850 an ounce.

Removing us from the gold standard did not come without an anticipated backlash. As the dollar was no longer backed by tangible assets, its value in the world markets was sure to decline and it did. Hence runaway inflation. In pre-emptive fashion, the Federal Reserve began to raise interest rates to protect the dollar.

At the same time gold trading began to spool up, the prime interest rate was at its lowest level in 12 years at 4.5%. The Fed Funds rate was 5%. These levels marked the bottom for interest rates during the period when gold began trading in earnest in 1972. Levels that would not be seen again for decades.

From that point on, both interest rates and the gold price rose steadily. By the time the gold price peaked at $850 an ounce, the Prime Interest Rate was 15.25%, 3.4 times its level when gold trading began. And the Fed Funds Rate at 15% was 3 times greater in the same period of time. With interest rates rising some 10 percentage points in 8 years, we learn the correlation between the rise in gold prices was a compounded 33% for every rise of just one point in interest rates. It must be noted, during the same period stocks rose a mere 1%.

If we now flash forward to find the next time interest rates reached an undisputed bottom, we find ourselves at a time just before Christmas 2008. On December 16, 2008 the Prime Rate moved from 4% to its current low of 3.25%. On the same day, the Fed moved its target Fed Funds Rate off of 1% to 0.00% - .25%. Where was the gold price at this key point in time? Precisely and ironically, gold was $850 an ounce.

Since December 16, 2008, both rates remain unchanged with no immediate signs of increase. Gold, on the other hand has risen from $850 an ounce to levels solidly above $1400 an ounce accounting for an annual compounded gain near 26%.

Looking back to 1972, we see rates and the gold price rose in lock-step with inflation. Today, we find ourselves in a lively debate over whether we are in an inflationary cycle or deflationary cycle. I will submit, as the markets express uncertainty over even this, the move higher in gold prices, since rates bottomed in December 2008, is more likely attributed to a safe-haven play than it is to inflation fears and rising interest rates.

Now a case can easily be made that the real gold bull market has not yet begun and will not until such time as rates begin a decided move higher. With interest rates locked in at these bottoms, there is only one way for them to go and that's up. And once that process begins, the real interest rate/inflation play can commence. So where is gold headed from here?

If history repeats, we can, once again, make the case that for each point rates rise we could see a 33% corresponding move higher in the gold price. If gold is $1400 an ounce at that time, just a 3% move higher in interest rates could see gold at $3290 an ounce based on current levels. A 4% rise would only be equal to a 12-month retracement of falling rates from December 2007 to December 2008. A repeat of such a retracement could put gold at $4375 an ounce or up 200% in just 12 months.

From there every added point to interest rates could become an explosion of its own as one single point higher in interest rates could see gold rise above $5,000 an ounce.

Is this possible?

In June of 2003, we find an example where the theory holds. As the country found itself digging out of the hole left by the Dot Coms of the 90s, interest rates had fallen to extreme lows. The Prime Rate was 4%, the Fed Funds Rate was just 1% and gold was $345 an ounce.

Again, in anticipation of inflation, the Fed began to raise rates. By June 2006, Prime was 8.25% and Fed Funds were 5.25%. Gold rose from $345 an ounce to a June 2006 high of $641.80. That translated to a 23% annualized return. As rates stopped rising and held for the next 15 months, the rise in gold price slowed to a more tempered but still pleasing, 12% annual rate. A clear indication that this move could be attributed more to rising rates and inflation fears than any other impetus.

Any way you look at it gold now has several ways to win. Rising debt, falling dollar, default, war, weak housing, stumbling markets and yes . . . rising interest rates.

Since April 2001, when gold prices hit a 22 year low of $255.95 an ounce, the gold price has risen some 400% as the gold market reacted to a myriad of various stimuli at different times. We have seen gold behave as a commodity, as for a time the gold price rose along with oil. We have seen gold prices rise in response to geopolitical unrest, 911 being case in point. And as markets have floundered we have seen the pure safe-haven play as the economy and markets became engulfed in uncertainty over rising debt a falling dollar and fear of default.

What we have yet to see is a sustained battle against inflation. A battle fought by raising interest rates. An imminent battle as the entire world works to re-inflate a global economy. When this occurs, the combined effect of rising rates, with any of the stimuli already shown to drive gold prices higher, could be explosive.

Watch for signs that the second great gold bull market in history is about to begin. For breaking news on the economy, the markets and the trend in gold, visit LearCapital.com to request a FREE Gold Advantage Investor Kit and Special Economic Reports.


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