Fed Days and Gold: How Interest Rates and the U.S. Dollar Move the Price

Gold can move several percent within minutes on days when the Federal Reserve announces its decision. Traders are not paying attention to gold news, they're paying attention to what the Fed might do to interest rates and the U.S. dollar, the two most consistent influences on the gold price in the short and medium-term.

This report details how interest rates and the dollar drive gold, how to analyze a Fed announcement, and why the typical relationships don't always hold true.

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Interest rates are important for the non-yielding asset because it does not produce income

Gold is also a no coupon stock and it doesn't pay a dividend. An investor who owns it loses the income that he or she would gain if he or she held cash or bonds. This is referred to as an opportunity cost. As interest rates go up, the opportunity cost goes up, and gold becomes less attractive, relative to that. The lower the rates, the cheaper the cost and better the gold.

Think about a basic example using round numbers. Suppose that you have $50,000 to invest and a safe bond offers 5 per cent. A year of interest on the money, $2,500, is the price of holding gold. If the bond yield is 2% then the income lost is $1,000. The less income you sacrifice, the more comfortable you can be with holding on to gold.

Real yields: the numbers that count

The nominal interest rate combines two things: what investors need to earn in real terms and what they anticipate inflation to be. Experts remove the inflation and consider real yields. A basic formula is:

Real yield = nominal yield minus inflation expectation.

If the 10-year Treasury bill rate is 4.5 percent and market participants believe that inflation will be 2.3 percent for the 10-year period, what is the expected real interest rate? The real yield is about 2.2 percent. A direct market measure is the yield on 10-year Treasury Inflation-Protected Securities (TIPS) from the Federal Reserve Bank of St. Louis's FRED series DFII10.

The general trend in gold prices and real yields over years is a tendency to opposite movements. When real yields fell sharply, as in 2008 to 2011 and 2019 to 2020, gold rallied. Gold has had a rough time when the dollar has strengthened, such as in 2013, or in 2022.

How the dollar fits in

The world price of gold is in U.S. dollars. When the dollar gets stronger, in comparison to other currencies, gold prices may also rise for the buyers who purchase the metal with euros or yen, rupees or pounds, and demand can weaken. If the dollar suffers a decline, gold becomes less expensive for the buyer and demand can increase. A broad measure of the dollar's value against major trading partners is provided by FRED series DTWEXBGS, and the popular U.S. Dollar Index (DXY) follows the dollar against a basket of currencies.

There is a relationship between interest rates and the dollar. Rising U.S. rates drive up the opportunity cost of investing in gold, and they simultaneously support the dollar. If rates rise in the U.S. compared to other countries, investors will want to buy dollars to make higher yields, further squeezing gold, and supporting the dollar.

Reading a notice about the Federal Reserve

The Federal Open Market Committee (FOMC) meets eight times annually. At each meeting, a number of pieces of information can move markets:

• Whether the committee raised, lowered or left unchanged the federal funds rate was the policy choice.
• The statement: a short text in whose words the changes are analyzed for indications of future policies.
• Summary of Economic Projections and 'dot plot': reported at certain meetings (revealing view of where the members of the committee think rates will be headed).
• The press conference: Where the Fed chair responds to questions and frequently sets the tone for markets more than the statement.
• The minutes: published about three weeks later, giving more detail on the discussion.

Importantly, markets are not reacting to the decision itself, but rather to surprises in the decision when contrasted with expectations. Let's say there's a broad consensus among traders that the Fed will cut rates and it does. Gold trades may be just a little bit of movement, as the cut had already been priced into the metal. Real yields could also start to climb upward, with a strengthening dollar, if the Fed signals fewer rate cuts than expected or simply holds rates, even as policy does not tighten, and gold declines.

The role of rate cycles in gold

In general, gold has done well when investors believed rates would be lowered or held low and it has not done well when investors believed rates would be increased or held high. This is a habit from cycle to cycle, although there may be variations from cycle to cycle. For instance, gold has at times fallen at the beginning of a rate-cutting cycle, when the rate decreases come with a financial crisis that gets people to sell off liquid assets in order to raise cash, such as briefly in late 2008 and March 2020.

When the relationship comes under stress

The rate and dollar model is a helpful guideline, but should not be taken as a rule. Real yields increased to levels that should have been a strong headwind on gold from 2022 to 2024, but this did not occur. Heavy buying by central banks, strong demand from investors in Asia and geopolitical concerns were cited. This is a reminder that there are multiple forces that affect gold, and relationships that are valued in the past might differ once new buyers come on board. Treat rates and the dollar as the starting point of an analysis, not as a complete analysis.

Note: This article is intended for general knowledge purposes only and should not be relied upon as financial, investment, tax or legal advice. There is considerable risk trading around economic events.