Understand how gold prices are affected by changes in interest rates, inflation, central bank decisions, and crises.
Gold is notable for its dual role as a precious metal and an investment. There are more significant factors influencing the development of gold demand and, therefore, its price than those affecting the growth of stocks. Though the gold price has tended to trend upward in recent years, it is also subject to frequent fluctuations. The gold price is significantly influenced by long-term, medium-term, and short-term factors. Global and national economic growth are among the more long-term influences. On the other hand, investors primarily affect the gold price over the short term through geopolitical crises and large-scale futures trading activity.
Fundamental and psychological factors influence gold prices to a large extent. So let us look at the six most common factors that affect gold prices.
1. Central Bank Reserves
Central banks hold gold and paper currencies in reserve. Many nations maintain gold reserves as a significant part of their reserves. It is common for gold prices to rise when central banks diversify their monetary reserves from paper currencies into gold.
According to the World Gold Council, central banks worldwide have been increasing their gold holdings over the past few years, thereby supporting the gold price. Approximately 35,000 tons of gold are now stored in central bank vaults, of which one-third is held by euro zone central banks (including the ECB), where gold makes up 60 percent of total currency reserves. If central banks change their long-term strategy, the market could become saturated with gold sales, dampening gold prices.
2. Value of the U.S. Dollar
Another significant factor influencing gold prices is currency movement — specifically the movement of the U.S. dollar, as gold is a dollar-denominated asset.
Because gold is denominated in dollars, its price is usually inversely related to the value of the United States dollar. Generally, a stronger U.S. dollar tends to keep the price of gold lower. In comparison, a weaker U.S. dollar tends to drive the price of gold higher through increased demand from investors holding currencies that have appreciated relative to the U.S. dollar.
3. Inflation
Inflation and the rising cost of goods and services can also impact gold prices. A rising or high inflation level tends to raise gold prices, whereas a lower level of inflation or deflation tends to lower gold prices.
The occurrence of inflation is usually an indicator of economic expansion and growth. In times of economic expansion, the Federal Reserve will likely increase the money supply. Money supply expansion dilutes the value of each existing monetary note in circulation, making it more expensive to buy assets perceived as a store of value, such as gold. Therefore, the expansion of the financial supply, which took place as a result of quantitative easing programs, was viewed by gold markets as positive.
4. The Level of Interest Rates
There has always been a perception that gold is the hardest currency in the world, as it is not subject to aging or decay and, contrary to some other assets, carries no default risk. However, gold does not provide any return in dividends or interest. As a result, its value only increases as its price increases, and it has a disadvantage over securities such as stocks, bonds, money market accounts, savings plans, and other investment products.
In general, gold prices are sensitive to changes in interest rates, which are most commonly triggered by medium-term movements in the country’s key interest rates, such as those set by the European Central Bank. When interest rates rise, some other investment opportunities may become more attractive, resulting in a gold price decline. In contrast, the price of gold benefits from low-interest rates, which are now common across many countries.
5. Supply and Demand
Although it is often overlooked, simple supply-and-demand economics can also impact the price of gold.
An increase in demand for a good or service coupled with a limited or low supply will increase its price. Conversely, an oversupply of a good or service combined with stagnant or weak demand can result in a price decline.
Throughout 2019, jewelry accounted for approximately half of the total gold demand, which amounted to over 4,400 tonnes, according to the World Gold Council. Another 7.5% of gold demand comes from its use in technology and industrial applications, where it is used to manufacture medical devices, such as stents and precision electronics. Regarding volume, India, China, and the United States are the largest gold consumers.
Accordingly, gold prices can be affected by the basic principles of supply and demand. As the demand for consumer goods such as jewelry and electronics increases, the price of gold may increase.
6. Uncertainty
The broad issue of uncertainty can influence gold prices.
No specific factor can be listed here that perfectly captures the uncertainty that can influence gold prices, but political uncertainty is probably the best example.
Due to its enduring value, people often turn to gold in times of economic uncertainty, as seen during economic recessions. During turbulent times, investors often consider gold a “safe haven.” An increase in interest in gold investing can occur if a bond, equity, and real estate return fall, which increases the gold price. Inflation and currency devaluation are economic events against which gold can be used as a hedge.
Unlike many other factors, uncertainty does not have a quantifiable statistic. Investors are affected by this psychological factor, which can differ from one event to another.
Bottom Line
Gold has long been enthralling us, and we expect to remain so. The current price of gold is influenced by several factors, including the demand for gold, the amount of gold held by the central banks, the value of the U.S. dollar, and the desire to keep gold as a hedge against inflation and currency depreciation.
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