Introduction
According to the greatest investors gold should have a significant share in the average investment portfolio.
In the last 90 years the price of gold rose by a remarkable 440% giving to its holder a handsome return.
But what affects the price of gold?
There ar many psychological and fundamental factors that drive the gold prices.
In this article we will focus only on the 10 most important factors, that are summarized below:
- The history of gold as stable medium of exchange
- Fluctuations of the US dollar
- Central Bank Reserves
- Fed Funds Rate
- Fed’s announcements
- Inflation Rate
- USA Economic Data
- Demand for “golden” consumer goods
- Global production of gold
- Uncertainty
The history of gold as stable medium of exchange
Gold coins have been used as a medium of exchange since ancient times.
The use of banknotes as we know it today did not start in Europe earlier than the 17th century.
Nevertheless, in times of war governments were deliberately devaluing the banknotes’ value in order to finance their increasing debt. For this reason, laypeople were reluctant to hold banknotes and they preferred to trade in gold bullions.
To convince people to use banknotes and copper coins, governments set a “gold standard”. Through this standard authorities agreed to exchange at any time in any commercial bank, banknotes and copper coins with god at a fixed price.
Based on this standard was born the “gold exchange standard” and subsequently the Bretton Woods System.
The Bretton Woods System was a system of fixed currency exchange rates. According to this system, the US agreed to link the dollar to gold at a fixed rate of $35 per ounce. All other currencies were connected to the US dollar with stringent exchange rates that could be readjusted only through IMF conferences.
The system collapsed during Nixon’s Presidency. The devastating war in Vietnam and the increasing US debt forced the US government to abandon the pledge to exchange gold to a fixed rate of $35 per ounce. A flexible exchange regime was adopted that regulates currencies until today.
Despite the fact that gold was downgraded as a medium of exchange, it is still considered by many investors as the ultimate medium of exchange and the only real shield against increasing debts.
Even today that the attention of investors shifted to digital currencies as bitcoin the interest for investing in gold increases.
Fluctuations of the US dollar
As we explained above, the dollar and gold had a very strong relationship during the Bretton Woods System.
After the economic collapse of all traditional European powers during World War II, the United States was the only fighter standing in the ring.
The international system was tailored to the needs and might of the USA.
Dollar became the indisputable international medium of exchange for all main commodities. Gold until today has been denominated exclusively in dollars. Therefore when the price of USD becomes stronger the price of gold decreases and vice versa.
The other factor explaining the negative correlation between USD and gold is the belief of many investors that a version of the “gold exchange standard” might revive, therefore gold functions as a “substitute medium of exchanges”.
Central Bank Reserves
Another factor that indicates the clandestine property of gold as a medium of exchanges is the cloak-and-dagger behaviour of the Central Banks.
Even though Bretton Woods was terminated in 1971 all large central banks hold gold in reserve that is worth billions of dollars. Many G7 nations, such as the USA, Germany, and Italy, have reserves that are composed primarily of gold (>70%).
As the central banks diversify their foreigh currency reserves (forex reserves) by buying or selling gold, the gold’s price is affected by these movements.
Fed Funds Rate
Undeniably the most important influence on the prices of gold is the Federal Reserve’s monetary policy. Federal Reserve (Fed) is the central bank of the USA and its main duty is to determine the rate with which banks lend funds to one another (called the interbank rate).
Nevertheless, when we listen to the news about the interest rate level set by the Fed we mean the Fed Funds Rate (which is positively correlated with the interbank rate).
The interbank rate affects the gold prices because of a microeconomic factor called the “opportunity cost”. Opportunity costs represent the potential benefits an investor is losing when choosing one investment over another.
For example, when the interest rate is near to zero, bonds and CDs yield nominal returns that might be even less than the national inflation rate. This practically means that investors are losing since the real returns of these assets are negative (real returns are calculated by deducting inflation from interest rate). In this case investors prefer to invest in other financial assets such as stocks and commodities.
Practically, if the Fed announces today that it will increase the Fed Funds Rate the price of gold will immediately fall.
Fed’s announcements
Fed’s commentary also can move gold prices.
Monetary policy in the USA is decided by the central committee of the Fed (called FOMC). FOMC meets eight times a year to discuss interest rates and vote on policies. Investors should track the announcements after these meetings to make correct investment decisions.
If the FOMC members make announcements implying that rates could rise in the nearest future, the price of gold will decrease for the reasons explained above.
Professional investors are also able to anticipate the announcements of FOMC’s members. FOMC has a specific inflation target. When the economy warms up and inflation rises investors bet on an interest rate increase announcement. This is the reason why the trading volumes before the announcements are comparably high. What drives the price of gold?
Inflation Rate
The rising price of goods and services (the inflation level) can affect the gold prices. Despite the fact that many recent studies have tried to rebuff a positive correlation between inflation rate and gold price, historical data indicate that the relationship exists and it is still strong.
Inflation in most cases is a sign of economic growth and expansion. Consumers, investors and producers feel more optimistic about the future and they start to buy products, services and supplies more aggressively.
This euphoria drives the prices up which can hurt the real value of money. Therefore, the Fed should intervene and increase the cost of lending (i.e. the Fed Funds Rate and consequently the interbank rate).
Inflation can also rise when the government is cutting taxes and increasing public expenses to ward off an imminent financial crisis due to a macroeconomic shock (i.e. war, terrorist attack, pandemic, stock market crash).
Educated investors anticipate the long-term increase of inflation and in the right moment acquire gold.
USA Economic Data
As you probably know inflation, gdp growth and unemployment are interrelated variables.
Each government (and central bank) set specific targets of what would be the optimum level of each of these variables. The US governments are targeting a 2% GDP growth rate, 2% inflation rate and 5% unemployment rate.
When the economy deviates from these targets the government is applying various fiscal policies (i.e. tax increases/reduces, spending increases/reduces) to bring the economy back to the correct course.
In the same way central banks are using monetary policies (i.e. interest rate increases/decreases, quantite easing, acquisition of bonds) to regulate inflation and consequently economic growth.
Investors should try to comprehend these macroeconomic rules before they try to understand how interest rates and inflations affect the financial assets.
And do not forget timing is everything!
As a rule of thumb, a healthy and strong US economy affects negatively the gold prices. The Fed would like to halt excessive growth by increasing the interest rates (i.e. lending cost, opportunity cost). Therefore, gold would be less attractive than bonds and CDs.
Nevertheless, things are not always straightforward. Sometimes the US economy might grow due to expansive monetary and fiscal policies. This GDP growth (and inflation increase) is not considered healthy since it increases public debt. Investors anticipate a financial crisis which immediately makes gold a more attractive asset than stocks and real estate.
Demand for “golden” consumer goods
Since gold is not a consumable good it is important to mention that in total there are about 190,000 tonnes of gold owned by governments, individuals, corporations and banks. Central banks hold approximately 30 tonnes.
Part of this gold in addition with the annually mined gold circulates in the economy through the law of supply and demand.
According to Bloomberg, in 2020, jewelry accounted for half of the gold demand, which totalled more than 5,000 tones.
Traditionally, China, India and the USA are the largest consumers of jewelry and consequently gold in terms of volume.
Another 9% of total global demand is attributed to industrial and especially technology uses. Specifically, gold is used in connectors, soldered joints, medical devices, GPS units, connecting wires and strips.
Consequently, the price of gold follows the basic theory of demand and supply. As demand for consumer goods manufactured by gold increases, the price of gold rises.
Global production of gold
Demand is just the one side of the coin. Supply and production equally affect the price of gold.
According to the latest report of the US Geological Agency (January 2021) there are around 55,000 – 60,000 tonnes of global gold reserves (i.e. gold that is profitable to be mined based on the latest mining technologies and the price of gold).
In the last decade (2010 – 2020), are mined 2,500 – 3,500 tonnes of gold on an annual level.
As in the case of oil the production of gold is controlled by a handful of companies that are extremely prudent in keeping the price stable.
The largest mining companies by revenue in the world are Glencore (CH, UK), BHP (AU, UK), Rio Tinto (UK, AU), China Shenhua Energy (CN), Anglo American plc (UK). All these companies are public and investors can invest in them through stock markets.
Inevitably, at some point all “easily to mine” gold will be extracted leading to its scarcity. Remaining gold will be extremely difficult to mine, leading the mining companies to invest in costly mining technologies. This additional operational cost in the long-term will be reflected in increased gold prices.
Uncertainty
The 29th of October, 1929, also called as Black Tuesday, was a gloomy day for the international stock markets.
The Dow Jones fell by a stunning 12%, signaling the commencement of the worst economic crisis in modern history.
The effects on the real economy were staggering. Between 1929 and 1932 the worldwide gross domestic product (GDP) fell by an estimated 15% sending to unemployment 30% of the global workforce; a colossal decline in comparison with the 1% decrease of the Great Recession (2008 – 2009).
Nevertheless, it was also a bright day for the shining precious metal.
The price of gold soared from $320 to $720 in 4 years. The demand for gold was so high that president Roosevelt decided to sign the famous Executive Order 6102 forcing all US citizens to sell their gold coins, bars and bullions in exchange of $20.67 per troy ounce (in effect confiscating them).
Undeniably gold is considered by many investors as a “safe haven” during times of economic recession. When the actual and expected returns on other financial assets stumble investors start hoarding gold due to its enduring value and its important role as a medium of exchange.
Conclusion
Ray Dalio advocates the participation of gold in all correctly diversified portfolios.
On the other hand, Warren Buffet considers gold an investment without utility due to its lack of ability to produce income or dividends. Specifically, he once said that is more effective to have a goose that keeps laying eggs, than a goose that cannot and just sits pathetically eating insurance and storage.
Nevertheless, Buffet’s company, Berkshire Hataway in 2020 – 2021 invested in gold mining stocks in the anticipation of a financial crisis.
Whether you decide to use gold for profit, hedging or speculation you should have a strong understanding of the powers driving its price.
As we saw what affects the price of gold is not so straightforward therefore critical thinking is indispinsable in any case.