Understanding the relationship between certain economic factors and the prices of financial assets is key to profitable trading. In this educational article, you’ll understand how interest rates affect the prices of certain financial assets.
For the sake of specificity, I would love to focus on commodity prices. How does the interest rate affect commodity prices?
What is Interest Rate?
The interest rate is one of the tools of monetary policy. Before I proceed, it’ll be good to have a good understanding of what monetary policy means so that you can have a big picture of the article’s objective.
Monetary policy is a set of tools employed by the central bank to control money circulation and promote sustainable growth in the economy.
The interest rate is simply the cost of borrowing money. It is the amount charged on loans. At a macroeconomic level, we can say that it is the amount commercial banks pay for borrowing from the central bank. Interest rates could be a contractionary or expansionary monetary policy tool, as the goal could be to reduce inflation or increase money supply and economic growth.
Smaller banks borrow money from larger banks at an interest rate so as to make small loans available to consumers and businesses. Generally, loans help boost economic activity as banks provide capital for businesses while still generating profit from the interest on such loans. Consumer loans also afford them the opportunity to buy homes and other consumer items. Hence, economic activity is happening at different levels.
You should know that the rate the central bank lends money to the smaller banks is very important as the rise and fall of this rate affects the rate at which these smaller banks lend money to consumers and businesses. But based on the article’s subject, how does the decline in the interest rate affect the price of gold?
Understanding the Nature of Gold and the Real Interest Rate
I will start by letting you know that gold is a non-interest-bearing asset. Secondly, I would love to create a distinction between the real interest rate and the nominal interest rate: the real interest rate is adjusted for inflation, while the nominal interest rate does not take inflation into account.
Gold has a negative correlation to the real interest rate, meaning that a rise in the real interest rate is not good for the yellow metal and vice versa. Because of gold’s non-interest-yielding nature, in the instance of a real interest rate hike, the opportunity cost of holding gold becomes high, making the yellow metal less attractive to investors. This is because they would prefer investing in interest-yielding assets like stock and other equity.
Over time, it has been proven that the price of gold increases significantly during a decline in the real interest rate. This is because when the rate of inflation is higher than the nominal rate, creditors tend to lose money and would prefer safe-haven assets like gold.
Think of it this way: instead of holding on to your money in an economy with a rising inflation rate, would it not be preferable to invest that money in a stable asset class like gold? Even though it would not yield interest, it would help sustain the value of your money. That is why gold is referred to as a store of value.
Bottomline
It has been discovered that the most significant rise in the price of gold has been when there has been a decline in the real interest rate. This is key to understanding how to profitably invest in gold or trade it.
