Demand and Supply With Gold
Gold production has declined overall over the past couple of decades, primarily because we have already extracted the higher grade deposits and are now down to lower quality ones, which previously may not have been economical to mine but with the price high enough this becomes more feasible.
We may expect that this will continue in the future, and as time goes on, the production of gold will continue to decrease, and this will influence the price of gold.
A fair bit of the demand for gold is for industrial use, in jewelry making and in electronics, and although this consumption doesn’t decrease the overall supply of gold very much, it does repurpose it.
Most of the gold ever mined is still around, and for instance if you buy gold jewelry, that gold can later be melted down and used for something else, but the gold that is used this way is not in a form that can be traded, like bullion or coins.
As the supply of mined gold continues to decrease, this does mean that the supply of gold for investment purposes will decrease, all other things being equal, in addition to the increase in demand versus supply on the industrial side.
These forces are nowhere near as powerful as what really drives the price of gold, and otherwise one might want to invest in gold just based upon a dwindling supply from mining and no real expectation that the demand for it for industrial purposes will dissipate.
If gold were just a commodity though, this reasoning may be pretty sound, even though we know that macroeconomic conditions can reduce this industrial demand and therefore there will always be a cyclical component to this investing idea.
Gold prices are driven far more by other forces, which stem from the very prominent role that gold as in investment themselves holds, and gold prices are in fact primarily driven from the supply and demand on the investment side, not the industrial side.
The Effect of Momentum on Gold Prices
Like all securities, the price of gold does move by virtue of momentum itself, much like stocks which are going up tend to attract more buyers looking to take advantage of the positive momentum, as well as causing more people to sell when the price is going down and worry about it going further grows.
While gold is driven a lot by other factors, in an order of magnitude that is much greater than with most other types of investments, we still need to account for the affect that momentum plays in gold pricing.
If you remember when gold hit its peak and the price rose to almost $2000 an ounce a few years ago, that’s a perfect example of the role that momentum can play in the price of gold. As the price rose, more and more people wanted to get in on the action.
The fairly steep rise accompanied by a fairly steep fall spoke loudly to how much of a role price speculation and momentum can play, as there was no other good explanation of such a move in both directions of these magnitudes.
While this is an extreme example, where price speculation overwhelms other forces in the market, this speculation does certainly play a role in the day to day pricing of gold. In this particular case, people are investing on more or less a technical basis, looking at the trend and wanting to go with it, and then looking at downward trends and looking to go with that as well and exit.
In this case, we can see that the demand rose quite a bit and then waned, with the supply side of things taking over as the price of gold corrected, seeing those who were looking to ride this move as well as others getting out after the move ended, which causes the opposing forces on the sell side to be magnified as well.
While we usually speak of gold’s role as a hedge and prices being primarily driven by these forces, we cannot forget that this is still driven quite a bit by price itself, as other securities are. This is why just taking a purely fundamental view of gold, looking at other markets and various economic factors isn’t sufficient to explain the movement of price with gold, although fundamentals are certainly more meaningful with gold than it is with something like stocks.
The goal here though needs to be to both look at these fundamentals if one is looking to invest in gold and also look at the momentum, although just looking at the price can suffice to do both, because the forces of fundamentals, our best predictions of them, will already be built into the current price, and tracking prices of course serves to measure momentum as well, and is the only way to measure it in fact.
Influences of Central Banks on Gold
Central banks hold a lot of gold, and also trade it in very large quantities when it chooses to, so this is a type of investor that we want to pay particular attention to. Central banks hold various amounts of their foreign holdings in gold, with the rest held in currency, as a tool to manage their economies.
The U.S. holds three quarters of their foreign assets in gold, and in comparison, China only holds about 2%. China is looking to buy more though and raise this proportion, and China has a lot of money they could spend on this, but at the same time they don’t want to overload market demand either and artificially drive up the price they pay too much.
Buying gold in the large quantities that central banks deal in, especially very large central banks, or selling gold in the amounts they do, does influence markets. This sort of trading drives currency markets a lot as well, and is why currency traders pay attention to moves from central banks, and the same principles apply here.
These decisions are based upon economic policy, and aren’t the sort of thing that we can obtain a lot of knowledge about, other than looking at general trends and see who is accumulating gold and who is distributing it. Once again though, this will all show itself in price trends, the part that matters that is, which is how moves like this do move prices.
Macroeconomic Influences on Gold
Gold has always been used as a hedge against currencies, in a similar way that central banks use it. Gold and the dollar for instance are inversely correlated, and people move out of currency and into gold when a currency weakens, especially the U.S. dollar.
Gold is seen as a hedge against inflation, for the simple reason that inflation devalues currency, but gold can keep up as its price can rise with inflation, as all goods can. If you have $1000 in currency, inflation will gradually reduce the value of this, but if you buy gold with it, gold can at least rise with inflation and keep its value, all other things being equal.
They aren’t always equal of course, and seldom are, but at least we have a way to protect ourselves against this one factor, and a fairly significant one, the risk of inflation. Inflation is the tendency for people to pay more for a certain thing over time, and among these things they pay more for is gold.
The other big factor influencing gold is its relative standing to other investments in terms of desirability. Price trends will affect this, as well as price trends in other markets, such as the stock market.
If the stock market is weak, people will tend to reduce their stock holdings, and look to invest elsewhere. Among the other places they choose to place it, primarily bonds and gold, this tends to cause an upward pressure on the price of gold by increasing demand.
The increasing demand and the higher prices this produces can also cause those holding gold to want to hang onto it more, which can reduce supply and cause gold to go up even more.
The reverse can happen as well, when stocks are bullish for instance and people move from gold to stocks more, and this will of course exert downward pressure on gold prices.
There are a lot of things that go into the price of gold, and this can become extremely complicated indeed, well beyond the abilities of individual investors or perhaps even anyone to predict with all that much certainty, the certainty required to feel good about our investments.
We can just look at the price movements and trends themselves though, and price tells are, it is all the factors that are involved exerting their various influences with the price trend being the net result. Regardless of what moved gold prices, we can see the effects of it in price charts, and if it is trending up or down this is a way that we can discover its real effects.
Editor, MarketReview.com
Monica uses a balanced approach to investment analysis, ensuring that we looking at the right things and not confined to a single and limiting theory which can lead us astray.
Contact Monica: monica@marketreview.com
Topics of interest: News & updates from the Office of the Comptroller of the Currency, Forex, Bullion, Taxation & more.