What will affect the price of gold?

The price of gold is affected by supply, demand, and investor behavior. This may seem simple, but the way these factors work together is sometimes counterintuitive. For example, many investors view gold as an inflation hedge. This has some common-sense rationality, because banknotes depreciate with the increase in printing volume, while the supply of gold is relatively stable. As it happens, gold mining has not increased the supply year by year. So, what is the real promoter of the price of gold?

Key points

  • Supply, demand and investor behavior are the key drivers of gold prices.
  • Gold is usually used to hedge against inflation because, unlike paper money, the supply of gold does not change much from year to year.
  • Studies have shown that the price of gold has a positive price elasticity, which means that its value increases as demand increases.
  • However, the growth rate of gold investment in the past 2000 did not make much sense, even when demand exceeded supply.
  • Since gold usually goes higher when economic conditions deteriorate, it is regarded as an effective tool for diversifying investment portfolios.

Correlation with inflation

Claude B. Erb, an economist at the National Bureau of Economic Research, and Campbell Harvey, a professor at Duke University’s Fuqua School of Business, studied the price of gold related to several factors. Facts have proved that the correlation between gold and inflation is not good. In other words, when inflation rises, it does not mean that gold is necessarily a good bet.

So, if inflation does not drive prices up, is it fear? Of course, in times of economic crisis, investors will flock to gold. For example, when the Great Recession hit, the price of gold rose. But until the beginning of 2008, gold had been rising, approaching $1,000 per ounce, then fell below $800, and then rebounded and rose as the stock market bottomed out. In other words, even if the economy recovers, the price of gold will continue to rise further. The price of gold reached a peak of $1,895 in 2011 and has experienced ups and downs since then. At the beginning of 2020, the price reached $1,575.

In their paper Golden dilemma, Erb and Harvey pointed out that gold has a positive price elasticity. This basically means that as more people buy gold, the price will rise with demand. This also means that the price of gold does not have any underlying “fundamental”.If investors start to pour into gold, the price will rise regardless of economic conditions or monetary policy.

This does not mean that the price of gold is completely random or the result of herding behavior. Some forces have affected the supply of gold in the wider market. Gold is a global commodity market, just like oil or coffee.

Supply factor

However, unlike oil or coffee, gold is not consumed. Almost all the gold that has been mined is still there, and more gold is being mined every day. If so, one would expect the price of gold to plummet over time as there is more and more gold around it. So why not?

In addition to the fact that the number of people who may want to buy it continues to increase, jewelry and investment needs also provide some clues.Just like Peter Hug, Director of Global Trade Chico, Said, “It ends up in a drawer somewhere.” The gold in jewelry is effectively withdrawn from the market for several years at a time.

Although countries like India and China view gold as a store of value, people who buy gold there do not often trade (very few people pay for washing machines by handing over gold bracelets). Instead, jewelry demand tends to rise and fall with the price of gold. When the price is high, the demand for jewelry decreases relative to the demand from investors.

Central bank

Hug said that the main market mover of gold prices is usually the central bank. In a period when foreign exchange reserves are huge and the economy is booming, the central bank will want to reduce the amount of gold it holds. That’s because gold is a dead asset-unlike bonds or even money in deposit accounts, it does not generate any returns.

The problem with the central bank is that this is precisely when other investors are less interested in gold. Therefore, the central bank is always on the wrong side of the transaction, even if selling gold is exactly what the bank should do. As a result, the price of gold fell.

The central bank tries to manage its gold sales in a cartel-like manner to avoid disturbing the market too much. The so-called Washington Agreement basically stipulates that the bank’s sales volume within a year will not exceed 400 metric tons. It is not binding because it is not a treaty; on the contrary, it is more like a gentleman’s agreement-but it is in the interest of the central bank, because immediately unloading too much gold on the market will have a negative impact on their investment portfolio.

The Washington Agreement was signed by 14 countries on September 26, 1999 and restricted the sales of gold in each country to 400 metric tons per year.The second version of the agreement was signed in 2004 and then extended in 2009.

ETF

In addition to the central bank, exchange-traded funds (ETFs)-such as SPDR Gold Shares (GLD) and iShares Gold Trust (IAU), which allow investors to buy gold without buying mining stocks-are now the main gold buyers And the seller. Both ETFs are traded on exchanges like stocks, and their holdings are measured in ounces of gold. Nonetheless, these ETFs are designed to reflect the price of gold, not to drive the price of gold.

Portfolio considerations

When it comes to investment portfolios, Hug said that a good question for investors is what are the reasons for buying gold. As a means of hedge against inflation, it is not effective. However, as part of a larger investment portfolio, gold is a reasonably diversified investment. It is important to recognize what it can and cannot do.

In real terms, the price of gold peaked in 1980, when the price of metal was close to US$2,000 per ounce (in 2014 US dollars). Since then, anyone who buys gold is losing money. On the other hand, investors who bought it in 1983 or 2005 are now happy to sell it. It is also worth noting that the “rules” of portfolio management also apply to gold. The total number of gold ounces held should fluctuate with the price. For example, if someone wants 2% of their portfolio to be gold, then it is necessary to sell when the price rises and buy when the price falls.

Retention value

One of the benefits of gold is that it does maintain its value. Erb and Harvey compared the salaries of Roman soldiers 2,000 years ago with the salaries of modern soldiers, based on the amount of gold in these salaries. The Roman soldiers received 2.31 ounces of gold each year, while the Centurion received 38.58 ounces.

Assuming US$1,600 per ounce, a Roman soldier’s annual income is equivalent to US$3,704, while the private income of the US Army is US$17,611. Therefore, a private U.S. Army can obtain approximately 11 ounces of gold (calculated at current prices). In about 2,000 years, the annual investment growth rate is about 0.08%.

The centurion (roughly equivalent to the captain) earns $61,730 per year, while the captain of the US Army gets 44,543-27.84 ounces for $1,600, or 37.11 ounces for $1,200. The annual rate of return of 0.02% is basically zero.

Erb and Harvey concluded that the purchasing power of gold has remained stable and has little to do with current prices.

Bottom line

If you are paying attention to the price of gold, it may be a good idea to check the economic conditions of certain countries. As economic conditions deteriorate, prices will (usually) rise. Gold is a commodity that has nothing to do with anything else; in small doses, it is a good diversification element of the portfolio.

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