For centuries, people used gold as money. Gold is difficult to counterfeit, is durable and has a high weight-to-value ratio. Historically, this made it useful as a medium of exchange. Today, gold retains its usefulness as a repository of value, even though the metal no longer is used as money. For investors seeking to buy gold as a safe haven or to make a profit, understanding how interest rates and other factors affect gold is essential to making informed decisions.
The Nature of Gold
Gold is a storable commodity. That is, gold may be purchased and stored for long periods without deteriorating. As such, gold is in the same category as other minerals traded as commodities on world markets such as oil, copper and silver. One would expect that the price of gold would fluctuate in response to market forces similar to the fluctuation in other commodities. However, gold also retains its historic role as a "safe haven" in times of economic uncertainty. Demand for this safe haven affects the price of gold, a factor that may not be present with other commodities.
Interest Rates and Gold
The traditional view is that an increase in prevailing interest rates tends to cause a fall in gold prices. Harvard University says this is due ultimately to the fact that higher interest rates mean interest-paying investments such as Treasury bills become more attractive. The incentive to hold assets in the form of storable commodities such as gold is lowered. Demand falls as investors shift funds into other investments, so the price of these commodities, including gold, tends to fall.
When interest rates rise, you often see commodity prices fall more than purely theoretical models predict. This "overshooting" phenomenon occurs because businesses and investors tend to continue shifting their money away from gold until they feel it is undervalued by the market. At that point, the price may start to rise and then bounce back and forth until it reaches a stable level, when the lower price offsets the profit potential of alternative investments.
Kitco.com cautions against relying on interest rate changes alone as a predictor of gold prices. Other factors also have an effect and may overwhelm the impact of interest rate increases (or declines). For example, in 2011, interest rates fell to near zero and had nowhere to go but up. Since an eventual increase in interest rates was a reasonable expectation, one would expect the price of gold to start to fall or at least stabilize. However, gold prices continued to increase, partly do to expectations of rising inflation rates. However, "The Wall Street Journal" points out that safe haven demand also may have been a factor. At the time, economic uncertainty was high, prompting many investors to continue to prefer gold as a way to hold asset value. This safe haven demand is thus another factor investors must allow for when evaluating the effect of interest rate increases on gold prices.