The Big Three – the Dynamics Between Gold, US Interest Rates and the Usd

By Jameel Ahmad, Vice President of Corporate Development, ForexTime Ltd.

In the days when the Gold Standard ruled the world economy, it was simple. If a country had gold, it had power, wealth and status. During the great European alliances of the 19^th Century, the allies would send each other extravagant gifts made of gold, to demonstrate their friendship and wealth. Wilhelm I of Prussia was presented with a ‘kidjal’,a ceremonial dagger made of gold, by the Russian emperor, now worth 187,000 Sterling Pounds, for example.

The historical reliance on gold as a means of evaluating a country’s wealth and power changed considerably after two World Wars in the 20^th Century, when gold became a much more difficult asset to exchange, given its weight and the need for a more efficient system. Instead, gold became an asset that was of value for central banks to stockpile as a back-up investment. Paper currencies – or fiat money – were much easier to carry and use as a transaction method. The resulting efficiencies powered an international trading expansion and the world economy entered the era of globalization. As trade increased between countries, the banking system became larger and expanded in accordance with international demand.

Cue the rise of the importance of the interest rate. As countries like the United States realized the economic benefits of international trade and domestic economic health, there was the strengthening of the banking system through central banks like the Federal Reserve, which used to be decentralized and run by each state before becoming a federal-level enterprise. The Federal Reserve uses interest rates to signal economic health – if the economy is growing too fast and becoming overheated, it raises interest rates so that borrowing becomes more expensive, thus cooling off the economy. If there is a deflationary or recessionary trend, the central bank’s tendency is to lower interest rates in order to boost the economy, because it becomes more affordable to borrow and invest.

Although gold still retains its importance as a national investment, the Federal Reserve does not own any gold. The United States’ 10.4 billion-USD-worth of gold holdings is owned by the Treasury, and amounts to 10 percent of the world’s official gold reserves. But does the value of gold have an effect on interest rates or the value of the USD? One scenario says yes, it does have an effect, because the price of gold is inversely-related to the price of the USD, and the Federal Reserve’s interest rate decisions have a direct impact on the price of the USD.

When the Fed decides to raise interest rates, the USD can increase in value – due to investor confidence in the US economy, and the price of gold can drop, because investment resources are being redirected to the USD instead of gold. Conversely, if the Fed decides to lower interest rates because the economy is not going well, then the price of gold can see a spike because investors see it as a safe-haven purchase, either to hedge their dollar holdings or simply as a better bet for the time being until the US economy recovers.

This was amply demonstrated during the global slowdown in the years between 2008 and 2015, when the price of gold rose to its highest level ever. In August 2011, gold rose to 1,900 USD per ounce, which was a record high. The USD was much weaker against its rivals, and only started to recover in 2015, contrasting to the price of gold which fell to below $1200 per ounce. The dynamics between gold, interest rates and the USD are fascinating to watch, and reading between the lines, one can certainly see that their intricate relationship is set to continue for the foreseeable future.

Jameel Ahmad

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