What Drives Gold Prices?

The Supply Side of Gold Prices

Prices of anything are a result of the combination of the forces of supply and demand, where the less supply there is and the more demand there is for something, the higher the price will be.

Changes in supply or demand upwards and downwards will affect price accordingly as with a given amount of demand, less supply available, or with a given amount of supply, more demand will create more competition and force those who wish to buy to pay more.

The same holds true for increases in supply or reductions in demand, which also affect the competitive forces in the market and prices will then lower in proportion to these changes.

Financial markets also see price as a function of the forces of supply and demand, for instance with stocks, if there is more pressure on the buy side, the demand side, prices will rise, and if more people are looking to sell their stock, this causes the price to fall.

With gold, there are actually two separate dynamics on the supply side, which are the actual supply of gold and the tendency for people to be willing to part with it. What distinguishes gold and other precious metals from other commodities is that while they all have industrial uses, gold also has an investment side, unlike, say, copper.

The actual demand for copper is going to be from its demand as a commodity itself, and no one stashes copper away as a long term investment, even though some people may pile it up in the short term while speculating on its price, someone who already holds copper and is just looking to time its sale.

This is sort of what happens with commodities in futures markets, only in this case the speculation is done on paper. With gold though, the fact that it is held as an investment is where the difference lies.

This works in the same way that stocks do, where there is a fixed amount of shares in circulation, but only a percentage of this is up for sale at any given time. How much and what percentage of these shares, or what percentage of gold holdings, is offered for trading does indeed affect the supply side of the price equation of these investments, and with gold, it affects it primarily.

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.

What Drives Gold Prices?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: [email protected]

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