After a two-day meeting on September 18, the Fed surprisingly cut its interest rates by 50 basis points.
The Federal Open Market Committee cut the federal funds rate to a range of 4.75% to 5% for the first time in four years and signaled that more cuts are likely before the end of the year. The Fed also noted that its goal is to keep inflation under control without hampering the job market.
There were expectations that a further cut could significantly boost bullion prices, but it ended with modest gains. This was due to a stable dollar that gained ground after the Fed rate cut.
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Gold has been bullish for the past several months on speculation of a rate cut. Lower opportunity costs, a weaker dollar, inflation concerns and increased investment demand usually drive up prices due to rate cuts.
When interest rates fall, the opportunity cost of holding non-interest-bearing assets falls. Low rates make bonds and savings accounts less attractive to investors. This increases the demand for bullion, causing its price to rise.
Rates are usually cut to stimulate the economy, but sometimes lead to inflation. Gold is traditionally seen as a hedge against inflation, so if investors expect inflation to rise due to low interest rates, they may consider investing in gold. However, the relationship between gold prices and interest rates is uncertain and volatile because gold prices in the global market are subject to factors beyond the control of the US Federal Reserve.
Gold prices also surged on fears of rising tensions in the Middle East after Hezbollah vowed to retaliate for the Pager attack. After an unprecedented cyber attack, the rising tension between Iran-backed Hezbollah and Israel could turn into a full-blown war.
Gold has a solid history as a crisis hedge because it has no credit risk and is not negatively correlated with risk assets. Hence, investors turn to it in times of uncertainty, volatility and geopolitical crises.
When geopolitical tensions rise, especially during war, investors become more risk-averse. They fear that conflicts could negatively impact financial markets and economies around the world. As a result, they resort to safe assets such as gold, which has historically been considered a safe investment.
Along with the foreign market, domestic prices have also increased. In the key futures market, the price has risen over 8 percent since July 23 since the government halved the duty on bullion to Rs. 73,000 per ten grams traded above.
Looking ahead, the outlook for gold remains bullish in the near future. The surprise rate cut suggests the US Fed is taking the threat of a slowdown in the US economy seriously, which could boost safe-haven demand for commodities. Likewise, rising geopolitical tensions may attract more investors to the metal because of its inflation hedge appeal.
(The author is Haresh V, Head of Commodities, Geojit Financial Services.)
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