Gold is something that fascinates us all at some level. Kings fought for it, explorers risked their lives for it and we’ve all been conditioned to believe it has an almost magical intrinsic value.
(If you want to listen to a captivating story explaining why we value gold so much more than any of the other basic elements on the periodic table, check out the Planet Money podcast “Why Gold”.)
As traders and investment educators, our fascination with gold went beyond the element itself. It took us into the realms how traders view gold and what makes them buy it. This exploration led us to write a book for McGraw-Hill in 2011 entitled All About Investing in Gold — a must read, if we do say so ourselves.
Fundamentals that Drive Gold Prices
When it comes to understanding what moves gold prices, it really boils down to the following three fundamental factors:
- Fear
- Yields
- Demand for physical gold
Fear comes in many shapes and sizes for investors. But when it comes to the fear that drives gold prices, it basically all comes down to one thing: the fear of a loss of purchasing power.
Purchasing power can be eroded in a variety of ways. Countries can experience hyper-inflation where the money you have in your wallet, your bank account or your investing account won’t buy as much today as it did yesterday. Countries can experience economic slowdowns that reduce demand for their currencies and make them less valuable in the global forex market. Countries can also experience a flight of capital due to the threat of war, economic sanctions, the possibility of a default on sovereign debt or general instability in the local financial markets.
Regardless of the threat, if traders are fearful, they tend to move their money to safe-haven assets like gold. We have seen this occur as investors faced increased risks of a Greek default or exit from the eurozone, heightened tensions in Ukraine and off-and-on concerns about the long-term inflation that may be unleashed by the quantitative easing (QE) programs implemented by various central banks.
This movement of money into gold in the face of all of these concerns increases the demand for gold, which in turn increases its price.
Yields play an important role in the value of gold because gold is a non-yielding asset. Gold doesn’t pay a dividend, it doesn’t have an attached coupon rate and it certainly doesn’t pay interest.
Gold has a much easier time competing in a low-yield environment because traders aren’t facing a large opportunity cost by putting their money in gold instead of a yielding asset like a government bond or a dividend-paying stock.
We are currently in an extremely low-yield environment. To fully appreciate this fact, you need look no further than the European bond market. Yields on 10-year government bonds have dropped to never-before-seen levels. As you can see in in the chart below, the yield on Germany’s 10-year bond has dropped to a mere 0.36%, while Switzerland’s 10-year bond has dropped into negative territory!
You can also look at the incredibly low S&P 500 dividend yield in the next chart and see that high stock prices have pushed dividend yields lower, making them less competitive with gold.
This low-interest environment decreases demand for other assets, which allows for more demand in gold.
Demand for physical gold is driven by both traders and consumers.
Traders increase demand for physical gold when they buy both gold bullion and gold-based exchange-traded funds (ETFs) like the SPDR Gold Trust (NYSEARCA:GLD) fund because the funds themselves hold physical gold in proportion to the amount of assets the fund has under management.
For example, the chart below shows how the net assets for GLD have fluctuated on a monthly basis during the past eight years.
In 2013, the fund’s assets peaked and have been declining ever since. However, we’re starting to see a bit of a bounce from the beginning of the year.
Consumers increase demand for gold primarily when they buy more gold jewelry. This impact is especially poignant in countries like India where people customarily buy a lot of gold jewelry for weddings, etc.
As you can see in this chart, physical demand — whether for jewelry or other uses — was down in 2014 and looks like it will be down again in the first half of 2015.
However, the rate of decline is decelerating, which could lead to more price stability in gold.
While the market environment we are currently in doesn’t set the stage for the same type of massive increase in the value of gold we saw after the financial crisis of 2008, there are many factors that could enable gold to break out of its downward consolidation pattern.
InvestorPlace advisors John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.
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