Gold prices: The top 10 most important drivers

1) US Dollar

Like most internationally traded commodities gold is priced in US dollars. At its most basic a decrease in the value of the US dollar relative to a commodity buyer’s currency means that the purchaser will need to spend less of their own currency to buy a given amount of the commodity. As the commodity becomes less expensive demand for the commodity rises, resulting in an increase in the price and vice versa.

The value of gold, a fiat commodity currency, will also 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.

Gold prices have a relatively high inverse correlation against the dollar of around -0.35.

2) US monetary policy

Interwoven into the value of the US dollar is the current and expected future path of US monetary policy. Higher interest rates, reflected in higher bond yields reduce the attractiveness of holding non-interest bearing assets like gold. However, it is not the nominal interest rate that affects the price of gold but the real interest rate, i.e. after inflation.

Gold is an asset that has no credit risk and in the long run maintains its purchasing power. How much should investors pay for it? Whatever the amount is, it would likely vary over time with the level of real yields available in very high quality, nearly “default-free” assets (such as U.S. Treasuries).

That is, when real yields on other such assets (i.e the interest rate on bonds) are high, investors would likely want a bigger discount to the long-run estimated real value of gold. Conversely, when real yields are low, the opportunity cost of owning gold drops and investors would likely be willing to pay a higher price relative to gold’s long-run estimated real value.

Since 2004 (when the first gold ETF was introduced and gold became an increasingly liquid financial asset). Over this period there has been a strong inverse relationship between the yield on the 10 year Treasury bond and the price of gold.

3) Jewellery / store of value demand

Gold is used for jewellery, accounting for over 50% of global demand. If consumer demand increases this may be reflected in higher jewellery demand, resulting in an increase in the price of gold.

Demand for gold in jewellery is particularly popular in China and India. Even gold jewellery is very popular, the metal is historically also used as a form of investment and financial security for married woman. Therefore, households tend to increase their purchases when prices fall, and vice versa when they rise.

4) Industrial applications

Around 10% of annual gold demand is attributed to medical and industrial uses for gold, where it is used in the manufacturing of medical devices like stents and precision electronics like GPS units. Due to the relatively small amount of gold going to industrial applications, changes in underlying demand have very little influence on gold prices.

5) Investment demand

Demand for gold as an investment (or hedge against uncertainty and higher inflation) tends to increase as concerns about higher inflation, prospects for a weaker US dollar and geopolitical risk grow. The growth in the market for Exchange Traded Funds (ETFs) have made it much easier for investors to take a position on gold. Previously, investors might have had to purchase gold coins and stored them securely. Since the first gold Exchange Traded Fund (ETF) was introduced in 2004 the marginal price of gold is now primarily set by investor demand.

6) Geopolitics

Gold and other precious metals are often also used as a hedge against uncertainty, and geopolitical uncertainty in particular. For example, gold prices peaked in 1980 at $850 per oz when 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.

However, these are just a few isolated examples. In reality the evidence is much more mixed that gold acts as an effective insurance commodity. In a 2009 study economists Dirk Baur and Thomas McDermott did find a safe-haven effect in relation to rich-country stock markets. The result was strongest just after highly unexpected events,“Gold can be seen as a panic buy in the immediate aftermath of an extreme negative market shock,” they wrote. “More gradual trends in stock markets – weekly or monthly losses – do not appear to elicit the same impulsive response from investors.”

7) The weather

The weather can sometimes have surprising impacts on seemingly unrelated commodities. In India, for example, the monsoon rains are crucial for the irrigation of crops. So how does the amount of rain falling in India affect the price of gold? Well, India is one of the top consumers of gold and significant amounts of its gold purchases occur in rural regions, with demand heavily dependent on agricultural income. Traditionally, Indian farmers ramp up their gold purchases after a good monsoon and harvest season, using the yellow metal as a store of wealth. With income from farming hit in the event of a bad monsoon season, the funds may not be there to support gold demand.

8) Above ground tonnages

Most of the gold ever mined still exists in accessible form and is thus potentially able to come back onto the gold market for the right price. Indeed, old jewelry scrap, coins and bars make up a significant part of the scrap pool (and they are arguably the only really price-sensitive elements in this market). Lower prices tend to result in lower levels of scrap entering the market with processors sometimes holding back material in the hope of higher prices.

9) Gold mining

At the end of 2006, it was estimated that all the gold ever mined amounted to 158,000 tonnes, enough to fit into a 20 m x 20 m cube. Given the huge quantity of gold stored above ground compared to the annual production (~2,500 tonnes), the price of gold is not particularly affected by changes in gold production from mines, e.g. a strike at a gold mine in South Africa.

One factor is that all the “easy gold” has already been mined; miners now have to dig deeper to access quality gold reserves. The fact that gold is more challenging to access raises additional problems: the miners are exposed to additional hazards, and the environmental impact is heightened. In short, it costs more to get less gold. These add to the costs of gold mine production.

Gold mining is an energy intensive process. Mining operations will see the biggest impact of weaker oil prices as metal production is by its very nature an energy-intensive process. In the simplest terms, cheaper energy inputs means lower production costs throughout individual cost curves.

10) Central bank reserves

Central banks and governments may also affect the price of gold, in particular through changes in the reserves of the precious metals that they hold. As of September 2015, central banks and other organisations held 32,682.4 tonnes of gold as official gold reserves, 21% of the gold ever mined. Central banks may sometimes look to off load or top up their gold reserves. One example of particularly bad timing was the decision by the UK government to sell off approximately half of its gold reserves between 1999 and 2002, when gold prices were at their lowest for 20 years. The UK achieved an average price of $275 per oz.

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