What Makes Gold Tick?
It’s everyone’s favourite metal. It’s been stacked, stolen, hoarded, hauled, mined and minted for millennia, but what actually actually drives the price of gold? What makes gold tick? Aside from the obvious demand for jewelry and supply/demand dynamics in general, there are a range of other market factors that determine the price of gold.
US Dollar Performance
A very important, but often overlooked driver is the performance of the US Dollar. As the vast majority of gold contracts are priced in US Dollars, there is an inverse relationship between the price of gold and the US Dollar. Generally speaking, if the USD is strong, gold will be weak, and vice versa.
This is not always the case though – if gold is rallying at the same time as the USD, that is a very good sign for gold bulls. Conversely, if gold can’t catch a bid, even as the US dollar falls, then that tells you gold is inherently weak. Why would this happen though? Why would the two assets move together?
Risk sentiment is a major driver of both gold and the US Dollar. Both assets are generally considered “safe-havens”, which means when there is strife in the world, people will generally look to buy gold and US Dollars. This could take the form of financial turmoil (large corporate bankruptcies, sovereign defaults etc), or geopolitical risks like wars, terrorist attacks etc.
When the world appears to be unstable, investors begin to question their riskier investments like stocks and corporate bonds, and head into perceived safe havens like gold and the US Dollar. In the case of a major crisis, Gold tends to outperform the US Dollar. This is because gold has intrinsic value and unlike the US Dollar and other fiat currency, the supply of gold is limited.
Other safe-haven assets include government bonds, the Japanese Yen and Swiss Franc.
Hedge against inflation
Why are the Japanese Yen and Swiss Franc considered safe-havens? Both of these nations have historically had very low rates of inflation. When risk aversion takes hold, investors stop looking for returns and shift their focus to simply protecting their wealth. In order to protect your wealth, you must store it in an asset that isn’t going to lose its purchasing power over time. This is another major reason investors buy gold.
Though gold has actually been a very poor hedge against inflation in recent times, over the long run, it has performed exceptionally well. If you’d bought 10 ounces of gold in 1967 and buried it in the ground, it would have cost you $355 and your gold would now be worth more than $10 000. On the other hand, if you’d just buried your $355 and dug it up today, it would still only be worth $355 and that money would buy you a whole lot less than it would have in 1967.
In a healthy economy, prices of assets and consumer goods tend to rise in a more or less persistent and linear fashion, this means your money steadily loses its purchasing power over time. When investors are predicting rising inflation, they will seek to hedge against this risk, by storing their wealth in gold and other safe-haven assets. Conversely, when inflation is persistently low or expected to fall off, investors are likely to divest from these assets.
Other than traditional supply and demand dynamics, the three biggest drivers of gold are US Dollar performance, risk sentiment and inflation. As gold is largely priced in US Dollars, Dollar strength and weakness affects the price of gold. Gold also rises when the world is in a perceived state of crisis and can sell off when such crises are resolved. Finally, gold has traditionally been a very good hedge against inflation, delivering exceptional average returns over the past 50 years, protecting the purchasing power of any wealth invested.