Inflation
Bullion has a history of being seen as a hedge against inflation, for some very good reasons.
Bullion is not subject to inflationary pressures like currency is. Currency becomes overvalued when the money supply increases. This is what inflation really is, inflation of the money supply, which causes a currency to lose real value.
The relative value of money depends on money supply, and if a government for instance gave every one of their citizens the equivalent of a million dollars, this would not make everyone rich. This would serve to dramatically drive up prices, where the buying power of a million dollars would be greatly reduced.
Those who had saved up money would now see the real value of their savings dramatically drop, although if one had invested in bullion, the price of their investment would appreciate in the same fashion that other goods would in such a dramatically inflationary environment.
In fact, bullion would go up even more than other goods because this will cause the demand for it to go way up, as people flee from cash and into an investment that isn’t subject to inflation like bullion.
When the money supply goes up, this causes currency to be worth less, but with bullion, it in itself isn’t subject to devaluation, and is actually neutral toward inflation. Its value in dollars is affected, but its price should move in step with the loss of buying power of its underlying currency. This is why it is seen as a hedge against inflation.
As is so often the case, there tends to be an overreaction of the market to these pressures, in other words people will tend to over hedge at times. The public doesn’t really buy bullion based upon fears of inflation as few people even know about how it can protect them against this.
Most people don’t have much of an idea of how they can hedge against inflation anyway, but a lot of bullion is bought by central banks who are well aware of all of this, and this is what drives this phenomenon the most. Large investors also may hold bullion for this reason, and the net effect is that hedging against inflation is the second biggest driver of bullion prices, second only to the relative value of the dollar.
Financial Markets
The next biggest driver of bullion prices is the behavior of other financial markets. While most people think of the stock market here, where people may sell part of their stock holdings and flee for what is thought to be the safer haven of bullion, it’s actually the bond market that affects bullion prices the most.
Large institutional investors, including governments, trade a huge volume of bonds and treasuries, especially U.S. treasuries. The bond market is simply massive, valued at almost a hundred trillion dollars these days, which dwarfs the bullion market, and is worth about 10 times more than all of the bullion in existence.
Central banks and governments do not invest in the stock market, but have enormous amounts to invest, and will hold both debt securities like bonds, or bullion, and how much bullion they hold versus bonds does affect the price of bullion pretty significantly.
Institutional investors will also hold various amounts of bonds and bullion, and together, this can and does move bullion prices a lot at times. This is especially the case when changes in financial markets due to improving or declining conditions will increase the degree of movement in and out of bullion.
There’s also the $70 trillion that is invested in the stock market having its say, and while the bond market does influence bullion prices more due to the size of the players involved, general movements in and out of the stock market does decide bullion prices notably at times.
The fact that the price of gold bullion rose during the 7 years prior to the bubble of 2007, and continued to rise in a similar way afterward, tells us that influxes from the stock market are nowhere as significant as many people believe.
Investor Sentiment
There’s no doubt that the hit that stock markets took during this recession did help keep the price of gold bullion going, prolonging its rise, and even accelerating it, but from looking at the gold chart it should be obvious that there’s a lot more going on here besides stock prices.
The price of gold actually declined quite a bit during the early part of this recession, which shows us that bullion and the stock market certainly do not have an inverse relationship. The real reason here is that money supply contracted for a time due to a pullback in credit, and almost all of the money supply consists of credit, therefore there was less money to put in anything.
Those who had a good portion of their investments in bullion did have this hedge their exposure to the stock market pretty well. The biggest effect though was having their investments in something else, where this percentage wasn’t exposed to the big hit.
In a matter of months, the decline was over, and this did give people time to move into bullion more as well, although many are just too married to the buy and hold philosophy that they were unwilling to time their positions even in the face of storm clouds such as these.
Some of course waited until things bottomed out to do something, and this is the worst strategy to have, even if you move into bullion then. At this point, the stocks they sold become a great value. While the market pulled back by around 50%, it didn’t take that long to gain it back and then some.
Aside from those who shorted during the decline, those who did the best in this market moved out of stocks and into gold during this drop, and then back into stocks as the price of gold topped out.
The appeal of bullion as a hedge or even for speculative purposes does move the markets a fair bit, and more so today than in the past as more individual investors are being turned on to the appeal of bullion as a component of their portfolio.
Some people invest in bullion for speculative purposes, although bullion does not typically have the potential of other investments. However, depending on the market conditions, it certainly can be, as we saw with the huge rise in gold from around $250 an ounce in 2001 to over $1800 10 years later.
The expansion of retail bullion sales does serve to increase the demand for bullion these days by making it more accessible to individuals. You can even buy bars and coins online now.
Other Factors
Bullion prices aren’t really affected by supply so much, simply due to the fact that supply is fairly constant and known. The gold rush days are well past us, and given that most of the supply of precious metals have already been mined and are already in circulation, supply doesn’t really affect the price much anymore.
Bullion does compete with other uses of precious metals, such as jewelry and industrial uses of the metals, and these other uses can affect prices, although not by a whole lot.
Even though these other uses account for over half of the precious metals mined, the fact is that all of the precious metals mined in a year only amounts to a fairly small percentage of the supply.
So, while we may think that how much is mined and how much is used for jewelry, or in electronics, wiring, catalytic converters, and so on must have a big effect on the price of bullion, the fact is that the effect of all of this isn’t really that significant.
Anything that affects the demand of the precious metal that bullion is created from is going to influence the price of bullion, as these prices are a function of the aggregate demand of the metal, regardless of whether it is to be made into bars and coins or rings and chains.
If we’re looking to determine where the price of bullion will be going, as is the case with other investments, there are many things to look at, but one can just monitor the price of a particular precious metal over time, as any and all influencers, the sum of all present knowledge about bullion or about any investment is going to be priced in.
The fact that bullion is less liquid than securities, especially if one is in physical possession of the actual bullion, can make it a little more difficult to liquidate one’s positions on a dime, but bullion is bought typically as a longer-term investment anyway. If one wants to trade in the underlying assets, there are several alternatives that can be bought and sold in an instant.
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
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