Lesson 5: Metals – focus on gold

In yesterday’s lesson you learnt more about the role that cycles play in commodity markets and why they can be so useful to investors. Today’s lesson takes a detailed look at one of the major commodities – the gold market.

Gold is defined as a precious metal – a rare, naturally occurring metal of high economic value. Other precious metals include silver and the platinum group of metals (PGMs), such as ruthenium, rhodium, palladium, osmium, iridium and platinum.

A store of value

However, gold is not like the other precious metals. Gold has no significant remaining industrial uses because equivalent or superior alternatives exist for all of its uses. As an example, although approximately 70 tonnes of gold are used in dentistry annually, it is gradually giving way to advanced composites and porcelain veneers and crowns.

Of course, Gold is used for jewellery. But even in countries like India, where gold jewellery is very popular, the metal is historically used as a form of financial security for married woman.

And so although all of the precious metals have at least some practical uses – from jewellery to industrial applications – gold stands out from the others because its demand is primarily driven by investment and as a store of value.

A fiat commodity

Gold is a “fiat commodity” – one that has value as an asset if and to the extent that enough people believe that it has value. Like paper, currency gold is “irredeemable”. It is an “outside” asset – an asset of the holder that is not a liability of anyone else.

As a fiat commodity currency, gold’s value will be largely determined by its attractiveness relative to other fiat currencies – the fiat paper currencies issued by central banks.

Gold will be most attractive when market participants are most nervous about the future value of other fiat currencies. And concern among investors tends to grow when governments appear to be spending too much (ie, increasing the size of their budget deficit) and/or when central banks do not do enough to contain rising prices. Inflation, of course, acts to erode the purchasing value of currency.

A means of payment

Before the introduction of fiat currency, precious metals and gold, in particular, were used as a means of exchange. The first use of gold as a means of exchange dates back to approximately 600 BC in Asia Minor (present day Turkey).

More recently the Bretton Woods Agreements established a system, after World War II, in which many countries fixed their exchange rates relative to the US dollar, and central banks could exchange dollar holdings into gold at the official exchange rate of $35 per oz.

A hedge against uncertainty

Gold and other precious metals are often used as a hedge against uncertainty, and geopolitical uncertainty in particular. Gold prices spiked to $850 per oz in 1980 after the Soviet Union invaded Afghanistan, which also coincided with the Iranian hostage crisis at the US Embassy in Tehran.

The rise to 2011’s record peak of $1,920 per oz came as several of the Arab Spring revolutions descended into civil war and Greece was brought to a standstill by a general strike against the Eurozone’s austerity demands.

More than any other commodity, gold seems to involve a stream of fantastic tales of imminent financial or societal collapse. Every potential problem gets blown up into a coming apocalypse. Gold is often marketed through a combination of fear and dishonesty.

I’ll end this lesson with a quote from the hedge fund manager Paul Brodsky: “Gold is intrinsically worthless or intrinsically priceless…You can build a financial model to value it, but every input is just going to be your imagination.”

I hope you found this lesson on gold and the role it plays in the financial system interesting.

In the next lesson we focus in more detail on one of the main energy markets – oil.

Go to lesson 6

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