Gold is supposed to dislike higher interest rates. Lately, it has been acting as if it has something bigger to worry about.
August inflation came in hotter than the Federal Reserve would like. Consumer prices rose 0.4% during the month and 3.4% from a year earlier. Core inflation increased 0.3%. Gasoline prices alone jumped 3.9% in August and are now 27.4% higher than a year ago.
The obvious market reaction followed. Expectations for another Fed rate increase surged, Treasury yields climbed and the 10-year yield pushed above 5%.
Normally, that combination should be bad news for gold. Instead, gold has remained remarkably resilient, which raises an interesting possibility: investors may be buying gold for reasons that go well beyond inflation.
Gold Is Breaking an Old Rule
The traditional gold playbook is pretty simple. When inflation rises, gold can benefit because investors want protection against the declining purchasing power of cash.
But when the Federal Reserve responds by raising interest rates, gold usually faces a problem. Higher rates make bonds and cash more attractive because they actually pay investors something, while gold does not. That is why a stronger dollar and rising Treasury yields have historically created serious headwinds for bullion.
We are seeing both right now. The 10-year Treasury yield climbed above 5% this week, reaching levels last seen in 2007. The 30-year yield has also moved above 5.4% as investors digest stubborn inflation, higher energy prices and enormous government borrowing needs.
Yet gold recently traded above $4,300 an ounce and has been far more resilient than the old relationship between gold and interest rates would suggest.
That does not mean interest rates suddenly stopped mattering. It means something else may now matter too.
Investors May Be Hedging Against the System, Not Just Inflation
There is a big difference between worrying about inflation and worrying about how policymakers deal with inflation.
Inflation is measurable. The government releases the numbers every month. Confidence is harder to measure.
Investors have to decide whether the Federal Reserve can bring inflation under control without triggering a recession, destabilizing financial markets or allowing borrowing costs to spiral higher. They also have to decide whether Washington can continue financing enormous deficits without eventually forcing investors to demand substantially higher yields to own U.S. debt.
Now those questions are starting to collide.
The Fed enters its September meeting with inflation still running above its 2% goal, energy prices creating new inflation pressure and bond yields already rising sharply. Markets also have to weigh the central bank’s policy decisions against political pressure for lower rates.
For gold investors, the actual rate decision may matter less than what happens afterward.
Watch the Bond Market
Suppose the Fed raises rates by a quarter point.
Gold could initially fall. The dollar could strengthen. Short-term Treasury yields could rise. None of that would be surprising.
The more important question is what happens to longer-term Treasury yields.
If the 10-year yield settles down after the Fed meeting, that would suggest bond investors believe the central bank is getting ahead of the inflation problem. That would probably be bad news for gold because the market would essentially be saying: the Fed has this under control.
But imagine the opposite. The Fed raises rates and the 10-year Treasury yield keeps climbing anyway.
That would be much more interesting. Investors could be signaling that one rate increase does little to solve the bigger problems surrounding inflation, deficits, government borrowing and long-term confidence in monetary policy.
If gold stays strong at the same time, that would make the message even harder to ignore.
The Strange Scenario Where Higher Rates Could Be Good for Gold
This is where the story gets counterintuitive.
Investors normally think of rising interest rates as bearish for gold, but there are two very different reasons interest rates can rise. Rates can climb because the economy is strong and the Fed is confidently tightening monetary policy. Or rates can climb because investors are becoming nervous about inflation, government debt and the long-term value of the currency they will eventually be repaid in.
Those are very different environments.
Gold tends to struggle in the first. The second could ultimately be much more supportive.
Think about someone buying a 10-year Treasury bond yielding 5%. Five percent sounds attractive, but the investor is also making a 10-year bet on inflation, fiscal policy, the dollar and the federal government’s ability to manage its finances without continually eroding purchasing power.
If investors become less comfortable making that bet, they demand higher yields. And some of that money may look for alternatives.
Gold is one of the oldest alternatives available.
This Is Why 5% Treasury Yields Matter So Much
The move above 5% on the 10-year Treasury deserves nearly as much attention as gold itself.
Long-term Treasury yields affect mortgage rates, corporate borrowing, commercial real estate, stock valuations and federal interest expenses. They also provide a real-time vote of confidence in economic policy.
The Federal Reserve directly controls a very short-term interest rate. It does not simply dictate what investors must accept for lending money to the government for 10 or 30 years. Markets determine those rates.
That makes the bond market particularly useful right now.
If the Fed raises rates and long-term yields fall, markets may be signaling confidence. If the Fed raises rates and long-term yields continue rising, the market could be sending a very different message:
You haven’t convinced us.
Gold investors should pay attention to that.
Gold’s Biggest Risk Might Actually Be Good News
There is another side to this story.
Gold has had an extraordinary run, and investors should be careful about inventing explanations that assume it must keep going higher. The cleanest bearish scenario for gold may actually be a relatively boring one.
The Fed raises rates. Inflation begins cooling. Energy prices stabilize. Treasury yields stop climbing. The dollar remains firm. Financial markets digest the tightening without serious problems.
Suddenly, investors have fewer reasons to pay more than $4,000 an ounce for insurance against monetary instability. A credible Federal Reserve and an orderly bond market could remove some of the fear premium that has helped support gold.
That is why the next Fed meeting matters even if the rate decision itself has largely been anticipated.
Three Things Gold Investors Should Watch
Ignore the temptation to judge the market by the first few minutes of trading.
Instead, watch three markets together.
Gold: Does it sell off sharply after a rate hike, or do buyers quickly return?
The 10-year Treasury: Does the yield fall because investors believe the Fed is getting inflation under control, or keep climbing because concerns remain?
The dollar: A stronger dollar combined with falling gold would suggest the traditional relationship is reasserting itself. A stronger dollar accompanied by surprisingly resilient gold would be far more unusual.
Together, those three markets may tell investors considerably more than the Fed statement alone.
The Bigger Question
Gold has always been described as an inflation hedge, but that description has never told the whole story.
Gold is also something investors buy when they become uncomfortable with currencies, governments, central banks or the financial system surrounding them. Sometimes those fears are justified. Sometimes they are not. Markets do not wait for a final verdict before adjusting prices.
That is what makes gold’s recent strength so interesting.
Inflation is still high. Treasury yields are rising. The dollar remains competitive with gold. And investors may soon receive another interest-rate increase.
Gold should have plenty of reasons to struggle. If it does not, investors should pay attention.
The real signal may no longer be whether inflation is 3.4%, whether the Fed raises rates by 0.25 percentage points or whether gold crosses another round-number price target. It may be whether investors still believe the people responsible for controlling inflation, financing the government and protecting the value of the dollar can keep everything under control.
That is a much bigger bet than the next Fed meeting.
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