Gold has been at the center of media attention as investors, financial institutions, and central banks have been purchasing gold to diversify their portfolios in light of concerns of a global economic slowdown.
Yet many retail investors don’t understand gold, how it works, and they myths versus facts that might make it an attractive investment. So, in this piece, we’ll cover the basics–namely, what drives gold prices.
What Drives Gold’s Price?
So, what drives the price of gold? As with any asset, fundamentals (supply and demand) and investor sentiment. That concept is simple enough, but not always adequate. Understanding what drives particular assets such as gold requires a more nuanced knowledge of their price dynamics. And that’s what we’re going to cover in this short piece, for the way in which these different factors influence one another can sometimes lead to mixed or conflicting results.
Let’s start with an obvious driver–inflation.
How Inflation Drives Gold Prices
It almost seems like a no-brainer–when inflation ramps up, purchasing power falls, the dollar declines, and gold prices rise. Except, it doesn’t always work that way. The gold-to-inflation correlation doesn’t have the same kind of lockstep motion as, say, bond yields to bond prices.
Although gold demand tends to rise during periods of economic turmoil, the exact timing and amount of gold’s price appreciation is far from predictable. So, in other words there is a correlation between inflation and gold prices, but the timing and trajectory of gold price is partly reliant on investor sentiment. Gold moves when investors realize that it’s time to invest in a safe haven. And often, the “herd” of public sentiment often moves too late.
Gold Investment During Bear Markets
When it comes to bear markets, gold investment is also driven by sentiment. Since investors often miss the beginning and end of bear markets–as secular bears begin in euphoria and end in panic–gold investments can also sometimes mirror this confusion.
Take the 2008 financial crisis, also known as the Great Recession. Gold prices rose significantly, but the path wasn’t very clear-cut.
At point , the bear market in US equities began on October 1, 2007–the S&P 500 reaching its highest point. There you can see gold rising. But then it follows stocks downward almost a third of the duration, rising toward the end at  when the S&P 500 reached its climactic selling levels, the bear market ending on March 2, 2009.
But if you look at the chart closely, you’ll notice that gold had been rising since before 2006, and it continued to rise strongly after the bear market had ended, from 2009 to 2011. Again, gold served as a strong hedge, as it was driven by fear, but its timing was not clear cut.
Although investor sentiment can seem a bit fickle and indecisive (it always is), one fundamental factor affecting gold price is that of global supply. No matter how investor sentiment drives the price of a given commodity like gold, it eventually catches up with the reality of supply and demand.
How Supply Affects Gold Prices
Gold doesn’t have as much industrial use other precious or base metals. There is some industrial demand, but mostly, gold is used to produce jewelry or is stored as an investment, as “sound money.”
According to the World Gold Council, the rate of gold mine discoveries have been falling for the last three decades. There have been new discoveries, but most have not been what experts call “world class” deposits. And the fact that gold has until now been on a steady downtrend since 2011, the returns for the cost of mining gold have been discouraging and potentially unprofitable. This lack of gold discoveries and investment toward new discoveries only serves to add downward pressure on supply.
In the 1970s, the average mine grade was over 10 grams per ton. Today, it’s around 1.4 grams per ton. This is not a promising sign for future gold production. Add to this the fact that central bank gold purchases in 2018 were the most seen since 1971, the demand for gold has far outweighed available supply. Hence, the recent rise in gold prices. And that’s yet another factor affecting the price of gold: central banks.
Central Banks Among the Biggest Players in the Gold Market
When the global economy is doing well, central banks would rather fill their portfolio with foreign exchange reserves, as international bonds generate yield (something that gold cannot do). Central banks typically unload their gold reserves (along with most investors), and gold prices fall.
In addition to this, central banks have been attempting to “manage” the price of gold for years (what they call price “stabilization”). Through the Central Bank Gold Agreement (CBGA), essentially a gold cartel-like intervention, central banks have agreed on how much gold each bank can sell to stabilize price without damaging each bank’s portfolio.
But the CBGA looks like it will not continue its operations in 2019, as central banks have been loading up on gold over the last few years (2018 being a record year of gold purchases). Also, China has been a net buyer of gold for years. While not part of the CBGA, China’s purchases have supported gold prices–its purchases having eased gold’s rate of decline.
ETFs and Gold
Another large category of players in the gold market consists of financial institutions that manage exchange traded funds (ETFs). An ETF is a basket of assets, similar to mutual funds–the main difference being that ETFs can be traded on a stock exchange on an intraday basis.
Investors purchase ETFs in order to gain exposure to a wide basket of securities or to indirectly hold an assortment of assets (commodities, currencies, real estate, etc) without purchasing each individual asset or security. SPDR Gold Shares (GLD) and iShares Gold Trust (IAU) allow investors to gain exposure to gold as both funds are backed by the physical metal. This makes the funds major players in the buying and selling of physical gold.
GLD holds approximately 9.600 ounces while IAU holds 5,300. Should either ETF experience capital inflows or outflows due to investor demand, it’s easy to see how both funds can move gold prices.
Why Investors Hold Gold
Because gold does not have a strong correlation to equities or bonds, some investors own gold to further diversify their portfolio. As a diversification tool, it can be used to hedge other assets within a portfolio. But it’s main appeal is to hedge declines in the dollar’s purchasing power in periods of inflation. And as we’ve seen above, investors, institutions, and even central banks turn to gold during times of market uncertainty or economic turmoil.
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