The 2 Reasons Gold and Silver Stocks Soared Following Today's Fed Rate Hike

By Sean Williams Markets Fool.com

Though not always the case, the Wall Street consensus on interest rates proved quite accurate today. The Federal Reserve, on the heels of strong economic data and inflation nearing their target 2% level, hiked its federal funds target rate by 25 basis points to a range of 0.75% to 1%. This marks just the third time in the past decade that the Fed has raised its key measure on interest rates.

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Though the Federal Reserve doesn't directly control interest rates, the repercussions of its federal funds rate increase sends a quick ripple throughout the financial sector that lifts interest rates on variable lines of credit, and it also boosts yields on interest-bearing assets, such as CDs, savings accounts, and bonds.

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The importance of opportunity cost for gold and silver

Generally speaking, Fed rate hikes are great news for investors looking to earn nearly guaranteed income from safe assets. In other words, today's rate hike is a big win for seniors who've continued to struggle for years with ultra-low yields on safe assets, such as Treasury bonds and bank CDs.

However, rate hikes are rarely ever good news for precious metals like gold and silver, or the mining companies that produce these metals.

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Everything comes down to opportunity cost, or the act of giving up one nearly guaranteed return in one asset in the hope of generating a larger return with a different asset. Physical gold and silver rely on opportunity costs to remain low. In short, they're counting on the yields of interest-bearing assets to remain relatively low and unattractive. If yields stay low and/or below the national rate of inflation, investors could forgo these safer income assets in favor of a potentially higher return with gold or silver, which offer no yield. If, however, the opportunity cost of making this trade-off rises (i.e., if yields keep rising), precious-metal demand by investors could fall, hurting the spot price of gold and silver.

The two reasons precious-metal miners soared on Wednesday

Taking into account the expected reaction of investors to the opportunity cost trade-off, Wednesday's spot-price action in gold (up 1.3%) and silver (up 2.6%) is probably a bit of a head-scratcher to many. Here's what was likely behind the move higher in these precious metals, as well as a number of underlying gold and silver mining stocks.

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First, we very well may have had a "sell the rumor, buy the news" event. Gold and silver stocks, along with the physical precious metals themselves, have been trending lower for the better part of two or three weeks in growing anticipation of a rate hike from the Fed. Today's hike, and the commentary from Fed Chair Janet Yellen, may have calmed the nerves of precious-metal investors because it contained no major surprises.

Wall Street has been factoring in the likelihood of three rate hikes from the Fed in 2017, and there was nothing contained in Yellen's commentary that further hikes would be needed this year. In particular, she even noted that inflation was expected to stabilize around its targeted 2% level this year, implying that a slow but steady approach to rate hikes is warranted. Translation: Things might not be as bad for the gold and silver market as previously advertised.

Second, it came as a bit of a surprise that there was a dissenting vote in today's Federal Open Market Committee meeting that of Neel Kashkari. Having a dissenting opinion this early in the rate-hike cycle could imply that the Fed's march to its targeted 3% federal funds target rate could be slower than everyone expects. That, too, could favor gold and silver stocks by keeping opportunity costs relatively low.

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These gold and silver stocks were big winners

However, precious-metal investors weren't today's big winners. That title goes to shareholders in the mining stocks that produce gold and silver. Here are just some of today's biggest moves:

  • Hecla Mining (NYSE: HL): up as much as 10%
  • Coeur Mining (NYSE: CDE): up as much as 10%
  • First Majestic Silver (NYSE: AG): up as much as 10%
  • Endeavour Silver (NYSE: EXK): up as much as 15%
  • Yamana Gold (NYSE: AUY): up as much as 10%
  • Golden Star Resources (NYSEMKT: GSS): up as much as 20%

Gold and silver stocks obviously benefit from a move higher in precious metals, since it can affect their margins. But there's much more to this move than merely "gold and silver prices went up." In practically every instance with these six companies, we're either seeing substantial inroads made in reducing costs to sustainably lower levels, or we're witnessing a major production expansion, which works out well with gold and silver bouncing off multi-year lows in early 2016.

Keeping expenses under control is crucial

On the cost side of the equation, Coeur Mining, Endeavour Silver, and Golden Star Resources have made, or are in the process of making, significant progress in bringing their all-in sustaining costs (AISC) down. This would imply that these companies will be in far better shape within a few years should gold or silver once again reverse course.

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Coeur Mining, for instance, is moving its operations entirely underground, which does boost its near-term AISC, but provides it with higher ore grade production in the not-so-distant future. It should also lower the company's capital expenditures, which will improve its margin and profitability.

Endeavour Silver is another company that's been quite prudent with its spending. Though its lowered spending caused its production to come in lower than expected in the fourth quarter, it managed to generate a full-year profit on a silver equivalent ounce AISC of $12.43. Best of all, Endeavour has existing mines and recently acquired projects that could help boost production should silver prices continue to rise.

Even mid-tier gold-mining company Golden Star Resources has made strong inroads in getting its costs down. Mines in Africa usually have higher cost structures, and there's typically more concern about political instability, which is why it's so important that Golden Star get its costs at its two producing mines under control. In 2016, Golden Star's AISC fell to $1,093 per ounce from $1,149 in the previous year. That's a good start, and one that could attract more speculative precious-metal investors with a higher tolerance for risk.

Expansion is important, too

Then again, some mining companies have thrown their cost worries aside in favor of expanding their production -- namely, Yamana Gold, Hecla Mining, and First Majestic Silver.

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Yamana Gold has a bounty of assets set to add to its already impressive production portfolio in the coming years. Cerro Moro and C1 Santa Luz are both expected to begin commercial production next year, with Cerro Moro generating 130,000 ounces of gold annually and C1 Santa Luz kicking in an average of 114,000 ounces of gold over its first seven years. Additionally, the recently acquired Riacho dos Machados gold and copper mine should ramp up from 55,000 ounces of gold annually to 100,000 ounces within two years.

Hecla Mining is focusing on expanding the production capacity of many of its core properties, including the newly commercial San Sebastian, as well as Casa Berardi and Greens Creek. It should be noted that Hecla has two of the 10 highest-ore-grade mines in the world, according to a recent Mining.com report, so its investment in expanding these mines should pay off handsomely for shareholders.

Finally, First Majestic Silver has ambitious plans to increase its silver production, from a reported 11.9 million ounces in 2016 to around 20 million ounces by 2020 or 2021. Like Hecla, First Majestic is planning to do this by organically expanding existing mines, as well as by bringing new projects online. In particular, Plomosas and La Luz could be set to come online within the next four years, with each adding around 2 million ounces of silver production annually.

While today's move higher in gold and silver stocks is likely based on the Fed's move not to offer as hawkish a view on future interest-rate hikes as expected, it's important that investors keep the longer-term picture in mind. In this respect, with costs falling and/or production ramping up for most mining companies, it remains a potentially undervalued industry that could be worth a closer look.

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Sean Williams has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.