How will Fed rate cuts impact Gold and Silver? Hint: Pay attention to real interest rates

The Federal Reserve is expected to cut interest rates by at least a quarter percent this week, dropping its federal funds rate to between 4 and 4.25 percent. What will that mean for gold and silver?

The metals have already gotten a boost from rate cut expectations, so there won’t likely be much effect from the cut itself. That has already been built into the price. The messaging coming out of the FOMC meeting will primarily drive market reaction after the meeting. If Powell hints that more cuts are in the pipeline, gold and silver will likely rally further. But if Powell & Company suddenly turn more hawkish and hint that future cuts will be limited, that could put a drag on prices. 

But what about the longer term? How will this apparent pivot to looser monetary policy impact the gold and silver market moving forward?

In a nutshell, an environment of lower rates will generally be viewed as positive for the metals.  

Gold, Silver, and real interest rates

Gold and silver are non-yielding assets. This means they don’t generally generate income from interest, dividends, or rental payments. Gold and silver’s value is derived from price appreciation alone.

When interest rates are higher, there is an opportunity cost to holding gold or silver when you could own bonds that generate interest income or stocks that pay dividends. However, when real interest rates fall or turn negative, those income-producing alternatives lose their comparative advantage.  In such an environment, the relative cost of holding precious gold and silver diminishes, making the metals more attractive as safe-haven and wealth-preservation assets.

What do we mean by “real” interest rates?

The real interest rate is simply the stated rate you see on the news adjusted for price inflation. 

To calculate the real interest rate, you take the quoted nominal rate and subtract CPI.

For example, let's say a 10-year Treasury bond is yielding 4 percent. That seems like a pretty good return. But if the CPI is running at 3.5 percent, the real interest rate on that bond is only 0.5 percent (4-3.5=0.5). 

Note that in a low-interest-rate environment or if price inflation is particularly high, real interest rates can go negative.

If that same 10-year Treasury is only yielding 3 percent and the CPI is 5 percent, your real interest rate is -2 percent. That means you will lose money in real terms if you buy and hold that bond (Assuming everything remains static).

If you take CPI data at face value, the current real rate is between 1.6 and 1.25 percent (That’s the Fed funds rate minus the current CPI of 2.9 percent).

If the Federal Reserve cuts its rate by 25 basis points, as expected, the average real rate will fall below 1 percent. Two or three more cuts will result in a negative real rate. And if price inflation continues to increase, negative rates will manifest even faster.

Keep in mind that the true price inflation rate is higher than the CPI indicates. The government revised the CPI formula in the 1990s so that it understates the actual rise in prices. Based on the formula used in the 1970s, CPI is closer to double the official numbers. So, given the current BLS estimate of 2.9 percent, under the old formula, you'd be looking at CPI closer to 6 percent. In other words, real rates may well already be negative.

And that means there is no opportunity cost to holding gold or silver.

This is extremely bullish for precious metals. It explains why their prices have rallied every time the Fed has hinted at cutting. And it’s one of the reasons many analysts believe the gold and silver rally has plenty of legs left.

The truth is (although they would never say it out loud), the central bankers over at the Federal Reserve prefer negative real rates because it softens the government’s massive debt burden.

As an investor, it’s crucial to pay attention to real rates. If you fail to grasp the concept of real interest rates, you can easily get fooled by media headlines. They will tout higher interest rates even when real rates are negative.

The inflation factor

It’s also important to remember that looser monetary policy is inherently inflationary. The whole point of rate cuts is to stimulate borrowing and spending (In other words, the move is to incentivize more debt). In a fractional reserve banking system, bank loans create new money. This is, by definition, inflation.

While the perception is that monetary policy is currently tight, it isn’t. The money supply has been increasing for well over a year. Again, this is, by definition, inflation. So, we are already in an inflationary environment, and the central bank is poised to crank up the inflation machine even higher.

This is yet another reason cuts are bullish for gold and silver. Gold, in particular, is an inflation hedge. It protects your wealth against this perpetual dollar devaluation.

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