If markets were logical we’d all be rich. But as long as they’re composed of human beings who are generally fearful, flighty and easily stampeded markets will never be logical. Even the machines that execute stock trades automatically are programmed by human beings, and thus can’t completely escape the irrationality of their masters.
But it turns out we really don’t want markets to behave rationally, because if they did we’d never make any money. It may sound a bit crass to spell it out so plainly, but people who are foolish with their money and trades provide opportunities for the rest of us to profit. At other times opportunities arise from a confluence of market forces that are less than intuitive. This is the situation we’re seeing in gold today. Gold prices are being depressed by counter-intuitive market forces, providing one of those rare times when we can all profit just by paying attention.
The “Fed Effect” on Gold Prices
It might seem odd that the Federal Reserve, which specializes in paper currency that’s backed by nothing, would have such a big impact on gold prices; nevertheless it does. Currently this is due to the Fed’s near-guarantee that they’ll be raising interest rates in December. Typically gold prices and interest rates move in opposite directions because, as prevailing wisdom has it, when interest rates go up more people leave their cash in the bank to collect that interest, and gold prices decline.
The problem (or the opportunity) is that we’re really talking about is the difference between 0.5% and 0.75% on the Fed prime rate. That’s not enough to change the dynamics of the gold market. Prime rate borrowers, like big banks, don’t hedge interest rates with gold. So it’s not the actual effect of a Fed rate hike that’s pushing gold prices lower; it’s the anticipation of an interest rate hike still more than sixty days off.
There is one aspect of the economy where small changes in the prime rate can make a big difference, and that’s the value of the dollar. When interest rates go up, foreign capital floods into the United States Treasury. The demand for U.S. currency pushes the value of those dollars higher. The buying power of the dollar is one of those factors that will have a direct and immediate impact on gold prices. When your dollar buys more, that means it also buys more gold. Since the numbers on bills don’t change it’s the price of gold that adjusts. A stronger dollar means lower gold prices.
It Can’t Last
The peculiar thing about having a strong currency is that it’s not really that great for us. A strong dollar makes American-made goods more expensive, hence less competitive, in overseas markets. When overseas sales drop, companies here start thinking about laying off workers. Layoffs hurt a consumer economy like the U.S. far more than they do elsewhere. At some point, the Fed will have to intentionally weaken the dollar to keep U.S. goods and services competitively priced in foreign markets. When the Fed does that, gold prices will increase.
Buying on the Dips
Analysts disagree about the entry point for gold prices, but as a small investor you get to ignore the big money speculators. When you’re investing in gold as hedge against the buying power of your cash and holding it for ten or twenty years, then the initial price you pay isn’t nearly as important as the length of time you keep it.
In the 1960s the average person spent around $3.60 on groceries every week. Groceries cost less because the dollar was incredibly strong and still backed by actual gold. In 1960 you could buy an ounce of gold for around $34. Had you bought that ounce of gold in 1960, you could sell it today for over $1,200 because the dollar has lost that much value! The gold you bought in 1960 reflected the buying power of the dollar that year. The gold you buy now will likewise reflect the buying power of the dollar today, and then protect against its further declines into the future.