Dollar, Bonds and Gold

In the years running up to 1981 gold had a fantastic run, outperforming all other assets. The dollar was in free fall and so were bonds.

However, from 1981 to 2001 bonds outperformed gold by a long shot. Interest rates which had peaked in 1981 were steadily falling. This moved the price of bonds up, making them more attractive than gold.

But by 2001, interest rates had come so far down that many started to question how much further down they could go. Furthermore, the first of this century's three financial bubbles burst that year.

Fear of default in the bond market drove people to gold again. From 2001 to 2011, gold had another fantastic run. However, bonds did not fall during this period. Contrary to what many had feared, interest rates continued down, and bond prices continued to rise.

The bursting of the second financial bubble of this century contributed to the continued down trend in interest rates. When the crisis hit in 2008, central banks came together to push interest rates lower, thereby inflating the price of bonds.

However, by 2011 central banks started to talk about their plans to unwind their activities, and the mere mention of this made gold prices head for a decline. The more central banks talked about normalization, the more confident people got about the dollar and the future of the economy. Things were going to be fine, so why hold gold?

Yet, bond prices continued to fall, despite all the talk of normalization. Central banks continued their active participation in financial markets. They talked about normalization while doing the opposite.

It was not until 2015 that we got the first rate hike from the FED. It was a puny little increase. It did not impress anyone, and fear started to return to the market. Gold went up in response.

It was starting to dawn on people that rate hikes would not be sufficient to make the dollar stronger. It would, however, be sufficient to send bond prices lower. With bonds no longer a sure winner against gold, gold prices started a cautious ascent.

For every rate hike since, gold prices have reacted by going up. The vision of lower bond prices and a stalling economy is becoming more and more vivid. However, every time central banks talk of raising rates while doing nothing, gold prices fall. The old knee jerk reaction to tough talk is still there.

When the FED rose interest rates in December of 2017, gold went up. When the FED talked about raising rates further and faster in January 2018, gold went down.

But the truth remains that rising rates will be bad first and foremost for bonds. Only when interest rates are so high that they are likely to be going down over the long term will gold be affected negatively. This is the lesson from the run up in gold prices and interest rates that lead to the peak in 1981.

With interest rates so low that they can only go up over the foreseeable future, gold will do well.

Bonds are heading for a decline, and gold is headed for a rise. The only question is at what speed this will happen. Will it be long and drawn out, or quick and brutal? Only time will tell.