11 Factors that drive the price of Gold Commodity

There is something about Gold that makes it a part of every balanced and well thought out portfolio. It has a history, is real money, provides a hedge against inflation, and above all, is an all-weather friend. 

But did you know the factors that influence the price of Gold in the markets? Awareness of these factors can influence your wealth creation skills.

There are many factors that can influence the price of this yellow commodity, right from excavation and production, to reaching your household. Most factors are beyond your control. But knowledge about these factors can immensely help you to your advantage. 

Let us look at all the international and domestic factors influencing the Gold price:

1.Supply and demand

It may be an oft-overlooked point, but simple supply-and-demand economics has one of the biggest influence on gold prices.

As with any good or service, increased demand with constrained or low supply has a tendency to pull prices of that good or service higher. Conversely, an oversupply of a good or service with stagnant or weak demand can push prices lower.

As an example, according to the World Gold Council, gold demand during the first half of 2016 grew 15% to 2,335 tons, with investment demand surging 16% to one of its highest levels. However, the gold supply only increased by 1% during the first half of 2016, which represents the slowest rate of first-half supply growth for a decade. Growing demand and constrained supply lead to a drastic increase in Gold prices in the latter half of 2016.

With an annual demand equivalent to about 25 percent of the total physical demand worldwide, India is one of the largest consumers of gold. Demand for gold in India is interwoven with culture, tradition, the desire for beauty, and the desire for financial protection. Traditionally, there is a surge in jewelry demand during the festive and wedding seasons, leading to a rally in gold prices.

In 2019, jewelry accounted for approximately half of the gold's demand, which totaled more than 4,400 tonnes, according to the World Gold Council. India, China, and the United States are large consumers of gold for jewelry in terms of volume. Another 7.5% of demand is attributed to technology and industrial uses for gold, where it is used in the manufacturing of medical devices like stents and precision electronics like GPS units. 

2. Currency movements

The movement of currencies – very specifically the U.S. dollar, since the price of gold is dollar-denominated – is another strong influencer.

A falling U.S. dollar has a tendency to push gold prices higher because of other currencies and commodities around the world increase in value when the dollar falls. On the contrary, a strengthening U.S. dollar often comes about because of a growing U.S. economy. It also pushes down gold prices since gold and the U.S. dollar have an inverse relationship.

In India, the rupee-dollar equation has a role to play in Indian gold rates although it does not impact the global gold prices. Gold is largely imported in India, and hence if the rupee weakens against the dollar, gold prices will likely appreciate in rupee terms. So, a depreciating rupee may dent the demand for gold in the country. However, remember the change in rupee-dollar rates has no impact on international gold rates, which are denominated in dollars.

3. Correlation with other asset classes

It is believed by some economists that gold is a highly effective portfolio diversifier due to its low to negative correlation with all major asset classes. There is some evidence (and a lot of belief) that when equities are under stress, in other words when shares are falling rapidly in value, an inverse correlation can develop between gold and equities. The most recent example seen for this inverse relationship has been the impact of Covid-19. Gold has risen by over 35% since the start of the year when the equities fell almost by the same number - evidencing this inverse relationship.

Still, as a rule, gold shows no statistically significant correlation with mainstream asset classes. Over the last 2 months i.e. since June 2020, both Stocks and Gold have been moving northwards, thus making it difficult to conclusively prove this relationship.

However, Gold thrives in uncertainties and the global scenario has definitely been uncertain since Jan 2020 and continues to be so. Gold, therefore, protects one's portfolio from volatility because the factors, both at the macro-economic and micro-economic fronts that affect the returns from most asset classes, do not significantly influence the price of gold.

4. Government Gold Reserves

Central banks of most major countries hold both currencies as well as gold reserves. US Federal Reserve of the US and Reserve Bank of India are two prime examples of this. Whenever the central banks of large countries start holding gold reserves and procuring more gold, the price of gold goes up. This is because the flow of cash in the market is increased while the supply of gold goes down, thus triggering price rise on account of supply-demand mechanics coming in play. 

Buying or Selling Gold is an important tool in the hand of the federal bank to control unexpected and continuing surge or decline in the Gold prices in the market. Over the years, most central banks bought gold as a precaution against a volatile market scenario and the dollar.

According to the World Gold Council (WGC), the global gold demand increased in the second quarter of 2019 due to record-breaking purchases by the central banks of many economies. In 2019, Central banks reportedly bought 224.4 tonnes of gold in the second quarter, taking their gold purchase in the first half to 374 tonnes, which is most for any first half since 2000.

In 2018, the central banks had added 651 tonnes to their reserves, while the RBI added 42 tonnes. The RBI added more in 2019 and the country’s gold reserves now stand at a record high of almost 618 tonnes.

5. Uncertainty

A broad factor of uncertainty can dynamically influence gold prices. There's no one specific factor that can be listed here that perfectly encompasses the uncertainty that can move gold, but political uncertainty and/or instability is probably the best example. 

Put plainly, the stock market covets certainty, and it's often the enemy of gold prices. Not knowing how Brexit will turn out for the U.K. and Europe, who'll become the 45th president in the U.S., and whether terrorist threats in the Middle East can be dealt with, are all factors that can contribute to global growth uncertainty and aid in rising gold prices.

The one thing investors have to keep in mind is that uncertainty isn't a quantifiable statistic like many of these other points. It's a completely psychological factor that's investor-dependent, and it can differ from one event to the next.

People want to invest or buy gold to protect themselves from any such volatility and uncertainty. The preference for physical assets makes Indian households view gold as a safe haven, an asset to buy when other assets are losing value. Underlining gold's attraction as an asset for good times and bad, most investors would buy gold whether the domestic economy was growing or in recession.

It has been seen innumerable times that Gold usually does well during geopolitical turmoil Crises such as wars, which have a negative impact on prices of most asset classes, have a positive impact on gold prices since the demand for gold goes up as a safe haven for parking funds.

6. Inflation

When inflation rises, the value of the local currency goes down. So, the inflation-adjusted returns from most asset classes become negligible. At this stage, Gold is the only form of asset which can hold on its true value since the price of the Gold is determined internationally rather than locally. 

Therefore people tend to hold money in the form of gold. Therefore, in times when inflation remains high over a longer period, gold becomes a tool to hedge against inflationary conditions. This factor also pushes gold prices higher in the inflationary period.

7. Interest rates

Under normal circumstances, there is a negative relationship between gold and interest rates. Rising yield indicates an expectation of a strong economy. A strong economy gives rise to inflation and gold is used as a hedge against inflation. 

Also, when rates rise, investors flock to fixed-income investments that yield a fixed return, unlike gold which does not carry any such fixed return. So, demand takes a back seat with prices remaining flat.

8. Good monsoon

In a country like India, rural demand plays an important role in the demand for gold in the country which depends primarily on monsoons. India annually consumes 800-850 tonnes of gold and rural India accounts for 60 percent of the country's gold consumption. 

Therefore, monsoon plays a big part in gold consumption because a good crop allows the farmers to buy gold from their earnings and create assets. On the contrary, if there is a deficient monsoon, farmers tend to sell gold to generate funds.

9. Gold Production

Major players in worldwide gold mining include China, South Africa, the United States, Australia, Russia, and Peru. The world's gold production affects the price of gold, another example of supply meeting demand. Gold mine production was roughly 3,500 tonnes in 2018, up from 2,400 in 2010.

However, despite the increase over the ten-year span, gold mining production has not changed significantly since 2016. One reason is that the "easy gold" has already been mined; miners now have to dig deeper to access quality gold reserves. The fact that gold is more challenging to access raises additional problems: miners are exposed to additional hazards, and the environmental impact is heightened. In short, it costs more to get less gold. These add to the costs of gold mine production, sometimes resulting in higher gold prices. According to some estimates, the global demand for gold is 1,000 tonnes more than the supply. With no new mining capacity coming through, most of the gold is being recycled. Therefore, less supply is another factor for changes in gold rates. Inflationary pressures in the world economy are positive drivers of gold prices.

10. Producer hedging

Miners tend to sell their gold production in the futures markets to hedge themselves in case of a fall in price. This is termed as producer hedging. If producer hedging rises, prices naturally drop. 

Gold miners may choose not to hedge all their output and even reverse their hedged positions (de-hedge in industry parlance) by buying back the futures contracts sold in the past if they expect prices to head higher.

11. Scrap Sales

Gold is sold or pledged to raise cash. With job losses across the world on account of the pandemic, the recycled gold or scrap sale is expected to go up.

Due to the lockdown, large markets such as India have not seen scrap gold sales so far, as jewelry retailers remain shut and banks are not allowed to buy bullion back. But the situation may change after the lockdown ends. Increased scrap sales may push prices lower.

Summary

We have long been, and will likely continue to be, enamored by gold. Today, the demand for gold, the amount of gold in the central bank reserves, the value of the U.S. dollar, and the desire to hold gold as a hedge against inflation and currency devaluation, all help drive the price of the precious metal.

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• Why Gold is almost always a good investment
• Why cannot a country just print more money?

Regards

Manoj Arora

Official Website