The price of gold has risen dramatically in recent years, and a review of the factors considered to affect the price of gold may help us determine if this tread can hold. So, what drives the price of gold?
As with any commodity, the price of gold responds to supply and demand. When demand outstrips supply, it puts upward pressure on the price of gold, and vice versa. But the supply and demand function for gold differs in unique ways from other commodities.
Gold production volumes
The world’s gold production affects the price of gold. However, gold production volumes have leveled off in recent years. One reason is the “easy” gold has been mined and miners have to dig deeper to access quality gold reserves. This also implies that there are upward pressure on the cost of mining gold, which could make the marginal supply of gold price-dependent.
Gold stock
Gold is a durable metal, which implies that all the gold ever mined are still there, above the ground, and is owned by someone. No one knows for sure how much gold exists above the ground. The supply of gold therefore functions independently from gold production volumes.
Worldwide jewelry and industrial demand
Currently, jewelry accounts for approximately half of gold demand. India, China and the US are large consumers of gold for jewelry. Gold is also used in the manufacturing of medical and electronic devices, though this accounts for less than 10% of global demand.
Asian consumption demand
Much is often made about demand from Asia, in particular China and India. For instance, in India the demand for the metal is driven by traditional use of gold as an adornment and its value as an investment. However, the demand from this quarter is considered to be mainly price-driven, that is a higher gold price often translates into a significant drop in demand from India and China. Demand for gold in India is also tied to festival seasons.
Safe haven buying
In times of expected political and economic turmoil, people protect themselves from volatility and uncertainty by buying gold. The effect of geopolitics on the price of gold has been evident in the past, such as the gold price increases that followed the Soviet Union invaded Afghanistan in 1980, the US invaded Iraq in 1990, and the Arab Spring revolutions in 2011.
Wealth protection
During times of economic recession, people turn to gold because of its enduring value. As the expected return on bonds, equities and real estate fall, the demand for gold increases. Falling interest rates, which often accompanies economic recessions, also make investment in gold more attractive.
Interest rates
There is an inverse correlation between the price of gold and real interest rates. Gold does not pay interest, hence the opportunity cost of holding gold versus treasury bonds, for instance, is greater when interest rates are high. However, correlation does not necessarily mean causation. For instance, fear of inflation may affect both interest rates and the demand for, and as a result, the price of gold.
Currency exchange rates
There is an inverse relationship between the US dollar and the price of gold. Internationally, the price of gold is denominated in US dollars. A falling dollar increase the value of the currencies of other countries, and of commodities such as gold. Also, when the US dollar loses its value, gold is seen as an alternative low-risk investment.
Stock market trend
Gold also often moves in the opposite direction to the stock market. Gold offers near perfect non-correlation with the stock market. In other words, you could reduce the inherent risk (or volatility) of your portfolio by including an investment in gold.
Inflationary trends
Over time, inflation erodes consumers’ buying power. Gold has long been seen as an attractive store of value in times of rising inflationary expectations. For a number of years now, inflation has been reasonably stagnant, but rising oil prices, the imposition of trade tariffs, and loose monetary policies could spark a new inflationary price cycle. However, studies have not found evidence of a correlation between the gold price trend and the inflation rate.
Price elasticity of demand
The price elasticity of demand measures the change in quantity demanded in response to a change in the price. Whilst the price elasticity of demand for gold jewelry is negative, the investment demand for gold has been found to be positive. That means the demand for gold increases as the price go up. One explanation for this is that there is significant momentum buying of gold. Momentum investors buy in expectations of further price increases.
In conclusion, various factors have been identified as potential drivers of the price of gold over time, but it is possible that different drivers may be predominant at different times. The dilemma faced by investors is whether we can extrapolate past performance into the future, based on the current circumstances.
Suggested further reading: The Golden Dilemma by Erb and Harvey
Photo credit: Alexander Boden (CC BY-SA 2.0)
