So frequently today we rely on economically established perceptions that fail time and again, simply because the conditions in which they were established have changed. One of the economic clichés is that exchange rates will rise if interest rates rise. You can be sure that if there was still a Spanish Peseta or Greek Drachma and they were paying the sort of interest rates their sovereign bonds were paying now, these currencies would still be falling, why? Many feel that if interest rates rise, gold would automatically fall. But is that going to be true? There's a great deal more involved to this story than just interest rates!

Interest rate rises in a growing economy

In an economy like China's, borrowers tend to be businesses enjoying the remarkable growth rates of around 10%. Their businesses in general are thriving and income is either steady or growing with the potential to grow more, or easily pay down debt. If you throw 5 and 7% inflation at them on certain items, their ability to absorb those costs is enormous. These items may include oil and food which do absorb a large portion of discretionary spending, but are accepted as one of life's burdens that we all must endure. Usually, they can pass them on to their customers without them being driven away. In such an environment, interest rate rises then have the desired effect of tempering growth without stifling it. Overheating, at the risky end of the market, is restrained and that along with a remarkable cooperation with government objectives in the economy has the desired effect of keeping the economy growing without excessive strains in one part or the other.

Interest rate rises in a shrinking economy.

Where an economy is in recession and inflation starts to rise from food and energy inflation, the economy finds it extremely difficult to absorb such inflation, in all areas of the e economy. Traditional economics would have central banks attempt to ensure that such inflation does not flow into other areas, but it can only use interest rates to do it. This is like a misdirected sledgehammer in so many cases as it now imposes yet another burden on businesses that are struggling to survive and ensure minimum profitability. The effect of interest rate rises in this climate is to curtail business activity even more. At its worst, it can eventually precipitate a depression. By damaging already weak consumer confidence, its impact is that much greater and that much more difficult to recover from. If confidence is already undermined, then such further cost pressures send it spiraling downward. The U.K. may experience this situation in 2011 and 2012.

Interest rate rises in a 'stagflating' economy

Now let's take a situation not quite as drastic as that above. There is little to no economic growth and the economy suffers from the impact of food and energy inflation. Energy inflation is imported, so there is usually no way to restrain such price increases. Food inflation in economies that are not self-sufficient has the same effect. Now along the lines of traditional economics, inflation is the one factor that prompts rate increases. Whether it is a one-off spike, or a persistent rising of the oil price does matter, but these days there appears to be no respite from these, which now drive the price of oil to $113 per barrel. An interest rate increase, when it comes, becomes an additional drain of income, thus adding to the burden of a business that is struggling to survive and doesn't see any economic relief. The result is that the business now begins to suffer. It targets cost cutting, which in turn ensures the overall economy of the nation either continues to stagnate or declines into recession or worse.

The impact on currencies of rising interest rates

The theory that is usually accepted is that if you raise interest rates you raise the value of a currency internationally. This is true where an economy is growing in a sustainable way, provided exchange rates are not managed by the central bank or government. The 'carry' trade has the function of borrowing money from a low interest rate nation and placing it on deposit in a high interest rate paying nation, so placing downward pressure on one exchange rate and upward pressure on the recipient currency. It is another source of gain if the prospects for the currency where the funds are borrowed are poor and it is declining anyway. This allows interest gains to be enlarged by a capital gain on the exchange rate.

Where interest rates are rising but inflation is higher there exists a 'negative real' interest rate which will lead to an exchange rate decline. Where the decline is due to economic fundamentals, then rising or high interest rates may well not look attractive to outside lenders. This negates any benefits from interest rate hikes.

Illustration

Take for instance an individual that is over-borrowed and his business declines to the point where he cannot service his loans. The bank would usually call in those loans and if unable to, will sell the clients assets in an attempt to cover the debt. If that man were to approach another bank for more loans with which to delay sequestration it may be that he gets the loan, but to what impact on his balance sheet? He will, of course be forced to pay a higher interest rate. This will ensure the likelihood of repayment is reduced. The higher interest rate will by no means raise his credibility in the market place. Greece, Ireland, Portugal and Spain have moved into that category. The U.S. debt situation has recently been likened to Greece's. So to attract more foreign capital, would higher interest rates add credibility to the U.S. debt position? In that case no.

The U.S.

If the U.S. were to attempt to ensure zero 'real' interest rate levels by raising interest rates to that of internal inflation [including food and energy inflation], the impact would not be to make the dollar more attractive but to at best stave off the speed at which the dollar is falling in foreign exchange markets. What would happen is that state and federal borrowing would have to offer higher interest rates. This would hammer the bond market and frighten off foreign lenders as well as cause the economy to move into 'stagflation.'

Certainly, no such rate hikes will take place until the U.S. economy is able to maintain growth in the face of such rises. This may well take some time longer.

The Eurozone

The E.C.B. has let it be known that they will impose three interest rate hikes in 2011 in an attempt to rein in inflation primarily from food and energy. The E.C.B. is clearly of the opinion that the stronger Eurozone economies are able to bear these rises. Economic activity is concentrated in the stronger E.U. economies. While the E.C.B. is aware that such interest rate hikes will hurt its southern members, their relevance to the overall E.U. economies is not of significance. They are trading on the belief that the woes of these nations will not undermine confidence in the euro itself. In fact, the joy of having weak members in the Eurozone is that they help to keep the euro exchange rate down and the stronger members competitive internationally.

We feel they may have miscalculated in that the confidence in the euro may well prove mercurial should any more members need financial assistance to meet their debt obligations. Their inability to date, to finalize the composition and strategy of the bailout fund, may well lead to them being overextended on their balance sheet. Should the Eurozone subsequently slip into stagnation, they will be seen to be overextended.

Will the Gold Price go down as interest rates rise?

Again it comes back to confidence and the waning of instability. If U.S. interest rates move into real positive territory on the back of a sustainable recovery then the dollar will offer value. If the recovery has not gained real traction and rising interest rates still leave them negative 'real' rates, then the dollar will not offer value. In the former case U.S. gold investors may well liquidate their holdings to some extent. In the latter case there is little reason to sell gold holdings.

Will higher U.S. and Eurozone interest rates hurt the gold price in the present global economy?

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