What drives the price of gold?

I was talking to a friend the other day. He was worried about the pandemic and the ongoing economic crisis and wanted to know where to put his money. ‘I have some surplus money and someone suggested I buy gold during these times’, he said. But he didn’t quite understand why he must buy gold? Why during these times? Is it even a good investment?

I imagine a lot of people have the same questions.

But to answer these questions we need to understand the fundamentals of gold first

In the past, much before stocks and banks were created everyone bought gold with their savings. Not because it was the only form of investment, not because it would give them good returns even. But because it was a great store of value.

They filled it in pots and hid it well. To be used only for bad times, for emergencies. It was their safety net in case everything went to hell in a hand basket. A good friend in bad times.

The same holds even today. It was a great store of value back then and is today. In fact, it’s also proved to be a great hedge against bad times.

Gold, a great hedge for your portfolio against any global economic crisis

The chart below helps us establish that:

Note, how in 2008 during the Lehman crisis when the stock markets crashed the price of gold was up

Similarly, during this year 2020, the price went up as investors, surrounded by massive economic uncertainty, rushed to buy gold. 

 

Source: www.GoldPrices.org

So, it’s safe to say that when the prices of other flamboyant assets (equities, stock markets) fall, gold prices rise. Making it a great hedge for your portfolio against stock markets and bad economies. Much like insurance.

In fact, experts don’t even look it at as an asset class, they consider it a currency. And these characteristics prove that gold, in fact, is one:

  • That cannot be created unlike the paper currency of any country

  • Hence, no government can inflate/deflate the value of gold as they can with paper currency

  • Till date, no currency (even the U.S. Dollar) has lasted for more than 100 years

  • Moreover, people including Government trust it

  • It is highly liquid. You can exchange gold for any kind of goods in the middle of the night. 

All characteristics of Gold and a currency.

So, what factors drive the price of gold?

Now we know that during an economic crisis there is demand and therefore the price of gold increases. But what other factors drive the price of gold?

  1. US interest rates (inverse relation): One of the biggest determinants is the interest rate of U.S. Government-issued instruments. Note, how in 2008, the short-term interest rates went negative, the opportunity cost of holding gold as opposed to cash became positive. Subsequently, increasing the price of gold. Thereby proving that US interest rates and gold prices share an inverse relationship. So, if the price of gold rises it indicates that the US interest rates will remain low over the short-term.

  2. Expected value of the dollar (inverse relation): Another determinant of gold prices is the expected value of the dollar and its safety thereof. So, if the future of the US dollar is expected to underperform investors will invest in gold. Thereby increasing its price.

  3. Increasing demand for gold from India and China is also a growing factor affecting gold prices. As these economies progress towards becoming developed economies, their appetite for gold will increase.

So is gold a good investment in these times?

As we have established, you must expose your portfolio to gold in any kind of economic crisis. 

Even though it might seem we are at the end of the virus curve there is still a lot of uncertainty ahead of us. India is still battling with the first wave of the virus whereas other countries are at the precipice of a second one. 

Economists and experts may make numerous projections on where the economy will be. But they are all just based on assumptions, which are honestly on shaky grounds at best.

So, it’s safe to say that gold is a good investment in these uncertain times. It is a great hedge and will smoothen your portfolio returns. But there is a caveat to it. 

Don’t buy gold if you expect it to generate strong returns. Think of it as a no-yield asset instead, it doesn’t pay any kind of interests or dividends (unless you buy the Gold Sovereign Fund). Further, there is no guarantee that the price will continue to increase forever. It's like an insurance, you don’t expect your insurance policies to generate returns. (Experts advice investing less than 10-15% of your portfolio in gold).

In fact, I wish I never receive any returns from my money in gold. Because that would imply that the economy is in trouble along with all my other investments. 

I only just hope it continues to play the same role - A store of value.