What impacts the price of gold?

By Morningstar |  27-05-20 | 

We all know that individuals flee to gold when they lose confidence in governments or financial markets. Hence it is often called a crisis commodity. A safe refuge amidst economic or geopolitical tumult.

Before answering the question, Kristoffer Inton, director of equity research, basic materials, for Morningstar, classifies an asset as a safe haven if it holds, or even increases, its value during periods of market and economic uncertainty and downturns. A safe-haven asset should preserve capital, withstand market volatility, and provide diversification across a portfolio.

Gold demand gets impacted by interest rates.

On one hand, gold is just a shiny piece of metal, but it's rare. Because of that scarcity, its value tends to rise with inflation. During periods of high inflation, the value of cash and any investments denoted in that currency tend to decline. In comparison, gold tends to maintain its value in real terms due to its scarcity, leading to higher prices in nominal terms.

However, it offers no other potential return or payment because it's ultimately just a rock.

Bonds can generate returns through coupons, but they're not very scarce. Although a Treasury offers interest returns, it will typically lose value to inflation since terms are agreed upon at issuance and last until maturity.

As a result, real interest rates, or the relationship between inflation and interest rates, are what determine gold's investment attractiveness.

In an environment of negative real interest rates, when inflation exceeds interest rates, gold is generally more favourable than a Treasury.

Conversely, in a positive real-interest-rate environment, when inflation is lower than interest rates, Treasuries are generally more favourable.

Gold's attractiveness as an investment case tends to be weaker during healthy economic periods, particularly as higher interest rates increase the opportunity cost of holding gold. Though inflation tends to be stronger during these periods, we expect interest rates to increase if inflation exceeds levels central banks are comfortable with.

In the short term, gold prices tend to move based on investment demand, more so than any other end market.

Sources of gold demand are jewellery, industrial uses (electronics, dentistry, industrial applications), central banks and other institutions, gold investment in physical forms such as bars and coins, and investment vehicles, such as ETFs.

Investment demand is the most volatile source of demand, at times rising to be the second-largest category and at other times, declining and creating a negative demand shock.

The current economic and interest-rate environment has fuelled a resurgence in investment demand for gold.

The marginal source of gold demand is investment. As the marginal demand source, this has led to a sharp rise in gold prices. The effect of resurgent investment demand on gold prices is exacerbated by the slow-moving nature of gold supply--changing mine supply is like turning a tanker ship. New mines can take a decade or more from discovery to full production, and even short-term production increases from bringing back mothballed capacity or brownfield expansions can take years.

As a result, rapid spikes in demand can only truly be met by recycled demand, or the sale of existing gold by current owners. To encourage current holders to sell, higher prices are needed.

When it comes to gold as an investment, today's demand is tomorrow's supply.

Investment-driven buyers, especially through ETFs, can quickly sell when real interest rates rise.

Worth noting is that ETF-held gold has reached record levels, and its unwinding would significantly weigh on prices. Furthermore, the vacuum left by declining investment demand won't be filled by other categories.

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