In economics, an interest rate is the ratio in the mutual valuation of present goods against future goods. Since people prefer goods now to later, in a free market there will be a positive interest rate to reward deferring consumption. From the financial point of view, an interest rate is a rate at which interest is paid by borrowers (debtors) for the use of money that they borrow from lenders (creditors). To simplify, an interest rate is the cost of borrowing money, typically expressed as an annual percentage of principal.
There are many interest rates. One of them is the federal funds rate – an interest rate at which depository institutions lend balances (funds maintained at the Federal Reserve) to each other overnight, which affects the market interest rates, like commercial bank rates, mortgage rates or bond yields. Normally, interest rates (yields) rise as maturity gets longer due to the risks associated with time (see: yield curve). Market interest rates are a complex phenomenon, but they can be broken down into three main components: the risk-free interest rates, the risk premium and the inflation premium.
Interest Rates and Gold
Many people believe that the price of gold is inversely related to interest rates. However, it is only partially true. In fact, gold prices are driven not by nominal rates (which are not adjusted for inflation), but by real rates (which are nominal rates adjusted for inflation). The data confirms that there might not be negative correlation between gold and the federal funds rate or between gold and nominal bond yields (see the charts below).
Chart 1: Gold prices (London P.M. Fix, green line) and Federal Funds Rate (red line) from 1993 to 2006.
Chart 2: 10-Year Treasury Constant Maturity Rate (in percent, green line, left axis) and the price of gold (yellow line, right axis, London P.M. Fix).
Investors should remember that what really matters for gold are real interest rates, not the federal funds rate or nominal yields. The chart below shows significant negative correlation between real interest rates (the 10-year inflation indexed Treasury rate is a proxy for long-term U.S. real interest rates) and the price of gold.
Chart 3: 10-Year Inflation-Indexed Treasury Rate (in percent, green line, left axis) and the price of gold (yellow line, right axis, London P.M. Fix).
We encourage you to learn more about gold – not only how it is affected by interest rates, but also how to successfully use the shiny metal as an investment and how to profitably trade it. A great way to start is to sign up for our gold newsletter today. It's free and if you don't like it, you can easily unsubscribe.