Uncertainty about the future has always driven the concerns of the investors. In the recent past incidents like The Bank episode, PMC Co-operative hoax has not only crippled the confidence of the investors but also forced them to look for alternative sources of investment. Nevertheless, COVID-19 has further added significant muscle to the investors’ uncertainty.
Globally, when the investors saw economies were reeling under immense pressure and found that their savings were drying up, they were looking for safer investment and were trying to conserve cash. Talking about safe investment our young population has always undermined the ability of gold as an investment. Gold is a safe haven investment which not only generates descent returns in the long run but also hedges our portfolio against inflation and uncertainty, to a certain extent.
Equity markets are rated as more lucrative and a tempting option. But in the current scenario where markets have turned volatile and highly unpredictable, it has coerced the investors to go back to the drawing board and rebalance their portfolio. Rebalancing should not only aim at hedging against the volatility but it ought to be focused at strengthening the portfolio for the turbulent times to come, for which gold would be an excellent choice. Further, the fact that governments all around the world hold gold as a foreign exchange reserve underscores the significance of the metal.
While we plan to invest in the Gold, it is vital for us to determine the correct price level at which we ought to invest. The price level has a direct bearing on the gains you expect to reap from your investment. But here million dollar question is: What drives the price of the Gold? Which factors should be kept in mind?
There are number of factors that have bearing on the price of Gold, but certain factors are considered to be prime drivers. No single factor can influence the price of Gold hence each of the below mentioned factor should be understood in tandem with other factors to precisely determine the behavior of the Gold.
I hope that the following explanation will provide you an insight into the dynamics of Gold.
FACTORS WHICH DRIVE THE PRICES OF GOLD:
GEOPOLITICAL UNCERTAINTY:
The term “GEOPOLITICAL” simply put means the study of; power distribution across the globe and the authorities that have the power to enforce and maintain this distribution. Politics not only affects the economy of the concerned state but also has bearing on the economies worldwide since we operate in a globalized scenario.
The primary authorities in the world are Nation- States. Consequently they are referred to as containers of the power in the global international system. With Nation- States being sovereign actors having absolute power within their territories but they are not equal Geopolitical authorities. Amongst all, USA is the strongest that influences the investment and foreign policy of the others. Hence it becomes vital to keep a track of the events taking place in United States.
Political disturbances in the USA, to begin with poor handling of the pandemic followed by Cold war with China and then certain untoward incidents taking place, all have created an ambience of uncertainty in the state. Moreover, upcoming presidential elections in USA have further accentuated the vagueness.
When such geopolitical turmoil pours into the economy, investors tend to shift their investments from risky equity markets to Gold, to hedge against the uncertainty. With vaccine showing no sign of hope until now, and with the tussle between USA and China deepening, it is probable that the Gold will remain in demand for next 4-5 months owing to its safe haven quality.
RELATIONSHIP BETWEEN GOLD AND US DOLLAR:
The US dollar is the benchmark pricing mechanism for the Gold, hence there is a special relationship between price of Gold and the value of the currency of United States. Trends in the past have highlighted that there exist an inverse relationship between Dollar index and the price of the Gold. Simply put, when dollar index is strong, gold prices in the US dollar terms falls, conversely when the dollar index is weak a bullish trend is witnessed in the prices of the gold.
This happens because when the dollar appreciates, Gold becomes expensive in terms of other currencies. And as the price of any commodity surges its demand recedes since people are discouraged to buy it. While the relationship between value of US dollar and Gold is of prominence but this is not the only factor that has bearing on the price of the Gold. This factor has to be scrutinized along with other factors.
DEBASEMENT OF THE CURRENCY AND INFLATION:
Debasement refers to devaluing the currency i:e lowering the value of money. In the times when gold and silver coins used to be the currency, debasement meant reducing the metal content in them, hence helping the regulators to mint more coins and thereby increasing the money supply.
In modern times, since most currencies are fiat currencies and are not based on precious metal so debasement only requires printing more money or since much money exist in digital accounts it requires creating more money electronically.
How is debasement relevant to our topic? Debasement has negative effect on citizenry since it causes inflation. When economy is hit with inflation, people look at gold as an alternate currency, since inflation tends to erode the savings of people. Hence the demand for Gold increases in the inflation like situations
So far, The Federal Reserve (US) has printed $2.2 trillion while extending another $5 trillion through loans to banks. Congress has already passed $2.2 trillion of stimulus and is working to add at least $1 trillion more. However according to some economists (US) the concern is altogether opposite as US economy is suffering form so low inflation that even printing of money will not prop up the economy which ostensibly is heading towards deflation.
As far as India is concerned, RBI is not looking at printing of money as an option to finance their deficit since the inflation levels in India are already as high as around 7{551c903f756d5bf12b7d58e2eb1e8b74af35058efa7a05d3e7b41e9147979503}.
INTEREST RATE:
Well, the relationship between Interest rate and Gold is opaque and perplexed. This is so because some events hint at the fact that there exists an inverse relationship on one hand, certain incidents indicate a positive relation too.
One school of thought suggests that, as the interest rate rises it makes the interest bearing securities and bonds attractive, consequently Gold witnesses’ outflow of investment and hence its price tends to fall.
The other school of thought that prevails is, in real sense it is the stock market that bears the brunt of increase in the interest rate. This is so because increase in the interest rate has negative effect on the bottom line of the companies (Bringing down the net profit margins) hence lowering their valuations and making equities a bit less striking. It is due to this reason that with increase in the interest rate people tend to shift their investments either in the Bonds or Gold. So if not direct, the gold is indirectly affected with the increase in the rate of interest.
Relation between Interest rate and US Dollar also merits our attention. A higher interest rate (say in US) offers lenders a better return thereby attracting foreign ingress of funds and hence leading to raise in exchange rate. So the rising interest rate leads to increase in the value of U.S. dollar, pushing gold prices lower (because gold is denominated in U.S. dollars and as already discussed there exists an inverse relationship between US dollar and price of Gold). However the impact of higher interest rate is somewhat mitigated if the country has a higher inflation rate.
CONCLUSION:
To sum up, if you are looking forward to include gold in your portfolio, the above mentioned factors will help you determine the behavior and movement of gold. The equity markets and the globalized economy we operate in are quite dynamic. Consequently any price level suggested today may lose its relevance tomorrow. Instead a better course of action would be that, the investors gauge their objectives of the investment against the aforementioned factors. This will enable them to determine the correct price level for taking a position. In the next article we shall discuss about the alternatives of investing in gold, their merits and demerits.