As a specialist in streaming arrangements and royalty interests, Franco-Nevada (NYSE:FNV) isn't a traditional gold and natural resources stock. However, its fortunes are clearly tied to those of the precious metals markets, and Wednesday's decision from the Federal Reserve to raise interest rates for the second time this year helped send Franco-Nevada stock down more than 3%.
Despite the knee-jerk reaction to a decision that had a negative impact on bullion prices, however, Franco-Nevada investors should understand that tighter monetary policy could end up having a net positive impact on the streaming company's prospects because of the way its business model differs from those of traditional miners. In that respect, Franco-Nevada shouldn't fear the Fed, even if it makes further rate hikes.
Why Franco-Nevada fell
At first glance, Franco-Nevada's decline seemed completely justified in light of the actions of the Federal Open Market Committee, which on Wednesday raised its target for the Federal Funds rate by a quarter percentage point to a new range of 1% to 1.25%. Immediately after the Fed decision, gold prices fell almost $20 per ounce, falling below the $1,260 level. Silver prices saw a similar percentage drop in declining below $17 per ounce, and declines in both precious metals continued the following day as well.
Gold investors generally see higher interest rates as being bad for the precious metals market. Because gold doesn't generate any income, the opportunity cost of owning it rises when rates on financial assets go up. Higher rates also tend to reduce the prospects for future inflation, which in turn dampens enthusiasm among those investors who like to use gold as an inflation hedge. Moreover, with the Fed outlining future plans to cut down the size of its balance sheet, further upward pressure on rates could result.
The downward move for traditional gold miners makes sense for a couple of reasons. First, lower gold prices are always a negative for producers of precious metals, especially those that have stopped using hedging transactions and therefore remain fully exposed to fluctuations in bullion prices. Also, mining is a capital-intensive activity, and many mining companies are highly leveraged with extensive debt levels on their balance sheets. Rising rates therefore make getting financing more expensive, further depressing profits.
How Franco-Nevada could benefit from higher rates
Yet it's that last point that's actually a potential positive for Franco-Nevada. With its streaming arrangements with mining companies, Franco-Nevada is actually the provider of financing for miners. More expensive capital from traditional lenders makes Franco-Nevada's alternatives more attractive to mining partners, and it also puts the streaming specialist in a better position to demand more favorable terms for itself. The resulting streams of precious metals replenish Franco-Nevada's cash coffers, allowing it to repeat the process and find more projects to finance.
Of course, that doesn't mean that Franco-Nevada is entirely immune to adverse moves from the Fed. When precious metals prices fall in response to higher rates, then the cash that the company generates from streamed metal sales drops as well. In addition, if mining partners become unprofitable, then their production declines, and that sometimes makes the streaming interests that Franco-Nevada owns less valuable.
However, at this point, interest rates from the Federal Reserve are far from reaching usurious levels. Even with the move, short-term rates of just over 1% and longer-term rates in the 2% to 3% range are extremely low from a historical perspective. As a result, only those mining companies that are right on the edge in terms of operational profitability will see a substantial impact from the Fed's decision.
Franco-Nevada's share-price decline in response to the Federal Reserve's latest rate hike isn't unexplainable, but it doesn't reflect the true change in the company's long-term prospects. If anything, measured rate increases could end up being a net positive for Franco-Nevada in the long run.