Aug 18, 2016, 9:56 am EDTJohn Jagerson and Wade Hansen, Editors, SlingShot Trader
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 that it has an almost magical intrinsic value. As traders and investment educators, our fascination with gold went beyond the element itself. It took us into the realms of how traders view gold prices 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. This week’s update is based on some of the material in that book.
The 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 comes in many shapes and sizes for investors. But when it comes to the fear that drives gold prices, it basically all boils 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 hyperinflation 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 foreign exchange 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.
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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 have faced the uncertainty of the Brexit vote in the United Kingdom, the decline in the value of the Chinese yuan and off-and-on concerns about the long-term inflation that may be unleashed by the quantitative-easing programs implemented by various central banks.
This movement of money into gold in the face of all of these concerns increases the demand for the shiny element, which in turn increases gold prices.
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. In order to appreciate this fact completely, you don’t need to look any further than the European bond market. Yields on 10-year government bonds have dropped to never-before-seen levels. As you can see in the first table from Bloomberg.com below, the yields on Germany’s 10-year bond and Switzerland’s 10-year bond have dropped into negative territory, down 0.06% and 0.55%, respectively.
You can also look at the incredibly low S&P 500 dividend yield in the second figure below, 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 like the SPDR Gold Trust (ETF) (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 figure 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 they declined through 2014 and 2015. However, after reaching a low of $22,342,698,373.25 on Jan. 4, GLD has seen its assets nearly double during 2016.
Consumers increase demand for gold primarily when they buy more gold jewelry. This impact is especially poignant in countries like India, in which people customarily buy a lot of gold jewelry for weddings, etc.
As you can see in the table below, physical demand — whether for jewelry or other uses — is down year-over-year by quite a lot.
This decline in demand is likely to apply some downside pressure to the price of 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 current consolidation pattern and continue moving higher.