What determines the price of Gold?

As gold prices rose almost 30% since the beginning of 2020, the global gold market has attracted a lot of attention. Basic economic principles have taught us that price of an asset, currency or commodity such as gold is moved by the forces of supply and demand. But the supply of gold is fairly predictable from year to year. According to a report by Fitch Solutions, gold production is expected to increase by a compounded annual growth rate (CAGR) of only 2.5% until 2029. So, what does really move the price of gold?

Gold Prices in USD/ ounce (Source: Macrotrends)

Gold is a physical asset that is accumulated rather than consumed. As a result, virtually all the gold that has ever been mined still exists today in one form or another. Gold Focus 2019 estimates that existing above-ground stocks of gold totaled approximately 191,000 tonnes at the end of 2018.

What Determines the price of Gold?

There are various factors that drive the price of the precious metal. These include:

Central Banks

Central Banks hold both paper money as well as gold in their reserves. Since they buy and sell gold in very large quantities, they influence the price of gold. According to Bloomberg, central banks around the world have added over 650 tonnes of gold to their coffers in 2018 alone. According to TradingEconomics, the CBE’s gold reserves reached an all time high of 79.60 tonnes in the second quarter of 2020 and has been increasing over the past couple of years. Advanced nations such as the United States have much higher gold reserves. The United States has over 8,000 tonnes of gold in its vaults.

The Washington Agreement was signed on Sept. 26, 1999. Under the agreement, the European Central Bank (ECB), the 11 national central banks of nations then participating in the new European currency, plus those of Sweden, Switzerland and the United Kingdom, agreed to limits the sale of gold for each country to 400 metric tons per year. A second version of the agreement was signed in 2004, then extended in 2009.

ETFs

Similar to central banks, exchange-traded funds (ETFs) such as the SPDR Gold Shares (GLD) and iShares Gold Trust (IAU) are big market movers of gold. Exchange-traded funds trade on the exchanges like stocks and measure their holdings in ounces of gold. The size of SPDR Gold Shares (GLD) holdings climbed to 1,258 tonnes in August 2020. This is more than major central banks around the world. It is worth noting that ETFs are designed to reflect the price of gold, not move it.

Value of the USD

In general, the price of gold is inversely related to the value of the US dollar. This means that a stronger US dollar would decrease the price of gold, whole a weaker US dollar would increase the price of gold, all else being equal. This is because as the value of the dollar increases relative to other currencies around the world, the price of gold becomes more expensive in other currencies. This leads to the drop in gold prices. The inverse is also true.

Interest Rates

Interest rates represent the “opportunity cost” of holding gold. Since interest rates are near their historic lows, bonds and CDs are, in some cases, yielding nominal returns that are less than the national inflation rate. This leads to negative real interest rates in those cases. In this instance, gold becomes an attractive investment opportunity despite its 0% yield because the opportunity cost of forgoing interest-based assets is low.

Worldwide Jewelry and Industrial Demand

According to the World Gold Council, jewelry accounted for approximately half of gold demand in 2019. Generally, gold’s price rises as demand for consumer goods involving gold such as gold watches or necklaces rises.

Source: Pexels.com

Portfolio considerations

Many investors consider gold a good diversifier. Especially investors that hold larger portfolios tend to allocate some of their holdings to gold. (If you’re interested in investing make sure to check out this article here) Studies have also shown that the purchasing power of gold is almost constant. This means that it is an excellent store of value.

Who Sets Gold Prices?

The IBA publishes the LBMA Gold Price which serves as a benchmark price for gold producers, investors, consumers, and central banks worldwide. Gold prices are determined twice each business day (10:30 a.m. and 3:00 p.m. London time) through an auction which provides reference gold prices for that day’s trading. The auction that determines the gold price is a physically settled, electronic and tradable auction.

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