What Affects Gold Prices? Factors to Consider
Gold prices are influenced by factors such as supply, demand, interest rates, and investor behavior. It is a common misconception that gold is a reliable hedge against inflation. Additionally, the value of gold can decline along with other commodities during periods of heightened risk. Furthermore, holding gold entails expenses for storage and insurance. To mitigate risk, it is advisable to limit gold holdings to no more than 10% of your portfolio.
Basics
Factors such as supply, demand, interest rates, and investor behavior play a significant role in influencing gold prices. While it may seem simple, the way these factors interact can be counterintuitive. For example, gold is often considered an inflation hedge, which makes sense on the surface, as paper money loses value when more is printed, and the supply of gold is relatively stable. However, the connection between gold and inflation is weak at best. In the short term, interest rates and overall market volatility are more reliable indicators of gold's performance.
Gold and Inflation
Economists Claude B. Erb and Campbell Harvey found that gold doesn't consistently move in line with inflation. An example of this is in 2022 when gold prices fell despite a 7% increase in inflation.
Interest Rates’ Impact
Interest rates have a substantial impact on gold prices in the long term. Gold prices surged when the Fed lowered rates in response to the COVID pandemic in 2020. As U.S. rates reached their lowest point, gold stabilized and moved sideways in anticipation of near-zero rates.
However, in 2022, as the Fed aimed to control high inflation, they signaled interest rate hikes. Interestingly, despite persistently high inflation, gold prices declined as the Fed increased rates and indicated a tightening policy, making interest-bearing securities more appealing.
Value and Market Dynamics
Gold's value can rise during times of economic uncertainty, but it's ultimately a commodity with a market-determined intrinsic worth. In moments of extreme market risk aversion, gold may decline, just like other commodities, as investors seek safety in assets like U.S. Treasuries. This balance between benefiting from market volatility and depreciating during turmoil is delicate.
In their paper "The Golden Dilemma," Erb and Harvey highlight that gold's price is positively elastic, meaning it increases with rising demand, irrespective of economic conditions or monetary policy.
While gold prices aren't arbitrary and can be influenced by supply forces in the global market, they primarily operate within the dynamics of a worldwide commodity market, similar to oil or coffee.
Central Banks’ Influence
Central banks often influence gold prices by selling gold when their economies are strong and reserves are high. However, they face a challenge since other investors may not be interested in gold during such periods, causing gold prices to decline. To manage their gold sales without disrupting the market, central banks have informally coordinated their efforts through the Washington Agreement, which limits annual gold sales to around 400 metric tons per bank. This agreement helps prevent adverse effects on their portfolios.
ETFs’ Influence
Exchange-traded funds (ETFs), like SPDR Gold Shares (GLD) and iShares Gold Trust (IAU), have become significant players in the gold market. They offer investors a way to buy gold without owning mining stocks. These ETFs trade like stocks and quantify their holdings in ounces of gold. However, it's essential to note that their primary purpose is to mirror the price of gold, not actively influence it.
Gold Supply and Demand
Gold is unique among commodities because it isn't consumed. Most of the gold ever mined remains in existence, and new gold is continually extracted. This might suggest that the price of gold should decrease over time due to its increasing supply. However, several factors prevent this from happening.
One significant factor is the growing number of people interested in buying gold. Jewelry and investment demand play crucial roles in this. For instance, gold used in jewelry is essentially taken out of circulation for extended periods.
Countries like India and China consider gold a store of value, but people in these regions typically don't trade it regularly. Instead, jewelry demand fluctuates with gold prices. When gold prices are high, jewelry demand decreases in comparison to investor demand.
Conclusion
Gold is unlike other commodities. It behaves more like a currency, closely tied to global interest rates. While it can benefit from market volatility, it may also decline with other commodities during extreme market swings. As such, it's best to keep a modest allocation of around 5% in a portfolio.