What Affects the Price of Gold?

A combination of supply and demand, interest rates (and expectations), and investor risk-taking behavior affects the price of gold.

Despite their apparent simplicity, the way those elements interact may sometimes be contradictory.

price old is seen by many investors as an inflation hedge.

This makes some sense since the quantity of gold stays relatively constant whereas the value of paper money decreases as it is issued more often.

At best, there is a weak relationship between inflation and gold.

Much more reliable predictors of gold’s short-term performance are interest rates and overall market volatility.

KEY POINTS

• The basic factors that determine gold prices are supply, demand, interest rates, and investor behavior.
• The mistaken belief that gold will appreciate and offset inflationary pressures leads to its frequent adoption as a hedge against inflation.
• The attitude of investors toward risk affects gold. This relationship is risky because gold might decline along with other commodities in the event of a risk-off commodity slump.
• Not only does gold not provide interest income, but it also has related storage and insurance costs.
• It is advised that gold make up no more than 10% of any portfolio due to its propensity for erratic swings and its seemingly arbitrary association with other assets.

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Connection to Inflation

Economists Campbell Harvey, a professor at Duke University’s Fuqua School of Business, and Claude B. Erb of the National Bureau of Economic Research (NBER) have examined the price of gold in relation to a number of factors.

Inflation and gold have a poor relationship.

Therefore, a rise in inflation does not always mean that gold is a wise investment.

The 2022 gold decline, which occurred at a pace of around 7% inflation, is the clearest example of this. (See the following chart).

The Risk-On/Risk-Off Character of Gold

Depending on the state of the market, gold may get support during times of economic and financial volatility.

At the same time, gold is a commodity with only intrinsic value, meaning that the market determines its value.

This indicates that gold is a stagnant asset since it may lose value with other commodities when investors sell their holdings of commodities in favor of safer options like US Treasurys during times of increased “risk off” sentiment.

There is a thin line between gold depreciating during periods of extreme market volatility, when it is liquidated with other commodities, and gold gaining during periods of moderate market volatility.

Erb and Harvey note that gold has positive price elasticity in their research, The Golden Dilemma.

In essence, this shows that rising demand causes prices to grow in tandem with an increase in gold purchases.

This suggests that there are no underlying “fundamentals” driving the gold price.

Gold’s price rises when investors are drawn to it, regardless of the state of the economy or the monetary policies in place.

Fact: The price of gold is neither only determined by collective action or wholly arbitrary. Like oil or coffee, the worldwide supply of gold, a commodity sold globally, is influenced by certain factors.

Supply-side factors

Gold, unlike oil or coffee, is not eaten. With new gold being mined every day, almost all of the gold that has ever been taken is still there.

As a result, one would expect the price of gold to gradually drop as its supply grows.

What is preventing it from doing so?

Along with the growing pool of possible customers, the desire for jewelry and investment offers insightful information.

Peter Hug, Kitco’s director of international commerce, said, “It ultimately resides in a drawer.”

For long periods of time, the gold used in jewelry is effectively taken off the market.

Even while gold is regarded as a repository of wealth in countries like China and India, people who buy it seldom trade it; for example, few people trade a gold bracelet for a washing machine.

On the other hand, jewelry demand often varies in tandem with changes in the price of gold. In contrast to investor demand, jewelry demand declines as prices rise.

Interest Rates Are Important

As the following data illustrates, interest rates have a significant negative impact on gold prices over the long run.

Following the Federal Reserve’s interest rate cuts brought on by the COVID-19 pandemic in early 2020, gold prices rose significantly.

Gold steadied and moved laterally as U.S. interest rates hit their lowest point, with Federal Reserve signals indicating that rates would stay at zero for the foreseeable future.

In response to high inflation in 2022, the Fed indicated that interest rates would rise until inflation was reduced.

Inflation was still rather strong during this time, but gold prices did not rise.

On the other hand, they began to fall as the Federal Reserve raised interest rates and gave tighter guidance, which made interest-bearing assets more attractive overall.

The Monetary Authorities

According to Hug, central banks are often the main factors influencing changes in the price of gold.

A central bank will prefer to reduce its gold holdings when the economy is doing well and foreign exchange reserves are significant.

In contrast to bonds or money in a bank account, gold is seen as a non-productive asset since it produces no return.

The problem for central banks is that other investors start showing less interest in gold at this same moment.

As a result, even though selling that gold is precisely the central bank’s stated role, the central bank always ends up on the losing side of the transaction.

As a result, the value of gold decreases.

To reduce market disruption, central banks have tried to control their gold sales in a cartel-like manner.

According to the Washington Agreement, banks are not allowed to sell more than 400 metric tons each year.

It is not legally enforceable since it is not a treaty but rather a gentleman’s agreement—one that is in the best interests of central banks because excessive market gold liquidation would hurt their holdings.

In addition to central banks, exchange-traded funds (ETFs) like the SPDR Gold Shares (GLD) and iShares Gold Trust (IAU) have become important buyers and sellers of gold, allowing investors to buy gold without buying mining stocks.

Both ETFs measure their holdings in ounces of gold and are traded on stock-like marketplaces. The goal of these ETFs is to replicate, not to affect, the price of gold.

Does Gold Make a Good Inflation hedge?

The real link is far more complicated, suggesting that the two are essentially uncorrelated, in contrast to market perceptions that gold is a good inflation hedge.

The aforementioned data shows that although inflation rose in 2022, gold prices fell as interest rates rose.

Does Interest Rates Have an Impact on Gold?

Gold often responds inversely to changes in interest rates since it offers no rewards other than price variations. Demand for gold decreases when interest rates rise in favor of interest-bearing assets like short-term U.S. Treasuries or other government securities.

How Does Gold Fit Into a Portfolio?

Since gold is a commodity, it should be treated as such, meaning that it will often follow broader commodity indexes rather than deviating much from the commodity market as a whole. Gold should thus only make up a small portion of a portfolio’s overall commodity allocation; the general consensus for a diversified portfolio is that gold holdings should not exceed 5% to 10%.

The Verdict

“Gold is the enchanting, lustrous metal from which dreams are fashioned,” goes a quote from the movie “The Maltese Falcon.” As a result, gold sets itself out from other commodities as a seemingly separate category with a number of distinctive characteristics.

The best way to describe gold as a currency is as one that has a high association with global interest rates and less liquidity.

Gold stands out for its comparatively low connection with other important assets; it may sometimes benefit from market turbulence while other commodities decline during periods of extreme volatility.

It is best to keep gold’s share in a portfolio to a small amount, like 5%, because of its propensity to act in a paradoxical manner.

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