The Gold Market
Gold has been a cherished asset for thousands of years. There are records of humans using gold as jewelry as far back as 4000 B.C. and in 1091 B.C. China legalized the use of little squares of gold as a form of currency. Gold is prized as an adornment, and is highly valued in jewelry but has also become an important investment vehicle.
Gold is a unique asset to hold as an investment because it appreciates in different economic conditions, and in circumstances where many other assets depreciate. For this reason it is advisable for most investors to have at least some exposure to gold in their portfolios.
How Gold’s Price is Determined
Gold is actively traded around the world, and its price is based on the balance of what price buyers are willing to purchase the commodity for and at what price sellers are willing to sell it. Also, a common benchmark for the price of gold has been the London gold fix. This price is determined by the LBMA Gold price auction, which takes place twice a day by the ICE Benchmark Administration.
Gold Price Drivers
Like most commodities, the price of gold is driven by supply and demand. Most of the world’s gold is used in jewelry and the second most significant use of gold is as an investment. It is important to note that demand for gold as an investment increased during the last recession when all sorts of buyers were attracted to the market as a means to protect their wealth.
This increase in investment interest also spurred the creation of many new investment vehicles related to gold that made the commodity accessible to a wider range of investors. Finally, some gold is dedicated to industrial uses but this is a small percentage of the market compared to investment and jewelry combined.
Gold’s market is a bit unique in that a fairly large portion of the demand comes from investors, making speculative demand a major price driver. This introduces some volatility for the commodity; as speculative buyers do not need to use the physical metal they can buy or sell their gold holdings on a whim.
India and China are the two largest markets for gold jewelry; therefore, the health of these economies is important to gold’s value. Both countries are considered emerging markets, and they are undergoing a rapid transition in which people are seeing their incomes improve. This trend has been going on for years, but China hit a hiccup in 2015, and for that reason over the year The World Gold Council calculated that global jewelry demand fell by 3%.
Gold jewelry is considered a luxury good, which means purchases can change quickly in response to fluctuations in economic health. When the economy slows, demand for gold, as a luxury good, can deteriorate rapidly.
Investment demand is becoming a more and more of an important driver of prices. While central banks have long been holders of gold, now thanks to the creation and expansion of gold investment vehicles from standardized gold coins through ETFs, gold investments are now accessible to pretty much any investor. This means that investment demand has a significant influence on gold prices.
When it comes to industrial demand, gold is valuable because a small amount of gold is used in almost every sophisticated electronic device. This portion of demand is also economically sensitive.
Gold is becoming harder and harder to find and extract economically, but this is not as big of a deal as it is for other commodities because gold is easy to “recycle”. Gold has a long life and a very large portion of the gold ever mined is still in circulation today as gold bars, coins, jewelry, etc. That being said, new gold needs to be discovered to meet demand growth.
What Dictates the Price of Gold?
While gold is no longer used to set currency, its value is directly tied to the value of global currencies, particularly the value of the US dollar because gold is still priced in dollars. Central Banks and the International Monetary Fund play a major role in the price of gold.
Central Banks and the IMF hold a large amount of gold reserves, with many limited to the amount of gold they can sell under the Washington Agreement on Gold. It is not the central bank’s gold sales that dictate price, it is their influence on interest rates. As interest rates rise the general tendency is for gold price, which earns no interest and has storage cost, to fall, and as interest rates dip, for gold price to rise. Central Banks therefore influence the price of gold through their monetary policy.
Central Bank’s monetary policy can also influence inflation and deflation, and the US Central Bank, the Federal Reserve, can influence the value of the dollar, which in turn impacts demand for the dollar-denominated commodity. It is apparent how the demand equation for gold is more complicated than many commodities. While we can see how economic health impacts jewelry and industrial demand, investment demand is more complicated, and the world’s Central Banks pay a big role on influencing investment demand for gold through their policy setting.