Why is silver sensitive to interest rates?

Why is silver sensitive to interest rates?
We shouldn't forget that apart from being an industrial metal, silver is also an investment metal. - Getty Images

Here's a clue: the metal's price falls right after a Fed rate hike.

By Dharmesh Bhatia

Published: Sat 6 Feb 2016, 11:00 PM

Last updated: Mon 8 Feb 2016, 8:10 AM

After nearly a decade, the decision to hike interest rates was taken at the US Federal Open Market Committee policy meeting during the end of 2015. The global market reacted for such big event, but have we forgetten what would be the effect of this decision on silver prices?
To fully understand this, let's look at how silver prices are tied to rates. How silver prices react to Fed rate hikes historically; silver prices have fallen right after a Fed rate hike. When the Fed raises interest rates, the value of the US dollar increases, which also makes dollar-denominated commodities more expensive. This makes buying silver less affordable, which lowers demand and sends silver prices down.
Higher rates also make investments that generate income more attractive than precious metals. From 1974-79, the real Fed funds rate was below two per cent. The Fed expected only temporary inflation from the 1973 oil crisis (note the real Fed funds rate is the funds rate minus inflation). Then there was a huge spike in silver demand around 1980. When the real Fed funds rate moved above six per cent in 1980-81, the price of silver fell from $50 an ounce to $10 an ounce.
Following the increase in interest rates, prices crashed and investors started to understand the future impact of a hike in interest rates as the days of the FOMC meeting came near and prices behaved naturally. The interest rate has been hiked to 0.25 per cent as per market expectations. No immediate effect would be visible on the prices; as this event was a major debate since a long time and the market has discounted it. Currently, silver prices are hovering around $14, but if interest rates would increase further phase-wise then prices may decline to $10.
We shouldn't forget that apart from being an industrial metal, silver is also an investment metal; it follows both fundamentals at one time or another. Not only due to overall weakness in the bullion metal besides interest rates hike, but due to the decline in the demand and prices of base metals, silver undertone has become more sensitive recently. So, we shouldn't be surprised that silver prices declined more rapidly than that of gold and touched the a six-year low. One short-covering rally in silver can be expected as the chairperson of the Fed has made cautious statements in the context of the US economy and the interest rate hike at Press conference. But it is difficult to predict that how sustainable this rally would be.
At present, sensitive and negative sentiment prevails in the market. You cannot ignore the very weak demand of the industrial metal. Given this, more price decline in silver is possible as compared to gold. Silver has broken all support levels of the last six years on the monthly chart.
The writer is manager of commodities market at Emirates NBD Securities. Views expressed are his own and do not reflect the newspaper's policy.

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