Context

Gold has been used as a medium of exchange and a store of value for thousands of years. Everybody loves gold. It is shiny, virtually indestructible (at least on a molecular level), impervious to corrosion, and has a limited supply. Accordingly, gold, unlike fiat, cannot be diluted by an increase of supply nor inflation.

It was not until the 1970s that the international ‘gold standard’ was abandoned. This allowed the price of gold to float freely. Since then, this precious metal has been viewed as an investment asset in a class of its own.

 

What Drives Gold Prices?

 From an economic perspective, three factors can influence the price of gold: (1) real government bond yields, (2) the strength of the USD, and (3) market sentiments.

Real Yields

The real yield is the bond’s expected return (i.e. nominal yield) less the expected rate of inflation. Gold prices and real yield share an inverted relationship. This means when real yields fall, gold prices tend to rise. Alternatively, when real yields rise, gold prices tend to fall.

The rational for this relationship can be explained through nominal yields and inflation. Ceteris paribus, when nominal yields increase, the opportunity cost of owning gold instead of bonds increases since bonds provide interest payments (i.e. coupons) while gold does not. However, when inflation is rising at a rapid rate, the opposite holds true as nominal yield and fiat currencies erode in value with goods and services costing more. Consequently, the stability of gold provides a safe-haven for investors since supply is limited.

 

Strength of the USD

Gold, like many other international commodities, is quoted in USD. If the dollar weakens, gold become cheaper to purchase overseas. This creates an increase in international demand, thereby increasing its price. Moreover, a weakening dollar also incentivises USD holders to seek out an alternative, and hopefully, safer store of value – gold. With another source of demand for the precious metal comes another increase in price.

However, there exists rare circumstances in which gold prices and the USD may both increase in tandem. For instance, in times of economic or financial distress, there is usually a ‘flight to safety’ to safe-haven currencies, namely the US dollar (USD), the Japanese Yen (JPY), and the Swiss Franc (CHF), and safe-haven assets like gold. This ‘flight to safety’ increases demand to both the currency and the precious metal, which results in upward price movements.

 

Market Sentiments

The final factor capable of influencing gold prices has already been mentioned in brief: market sentiments. During periods of financial volatility, most market participants prefer stability. Gold, with its limited supply, is one such asset. Gold’s limited supply, and our inability to create more, also provides a strong store of value when the public loses confidence in the central banking system. This phenomenon of absolute scarcity can help explain the traction cryptocurrencies have begun to gain in recent times following the wake of the 2008 financial crisis.

 

Why Should You Invest in Gold?

First, gold provides protection against inflation. Inflation is a normal part of the economic cycle, defined by rising/falling economic growth and rising/ falling inflation. Inclusion of gold can help the portfolio perform stronger in volatile economic environments and when inflation is running rampant. This is arguably why famous portfolio allocations such as the ‘All Weather Portfolio’ by Ray Dalio has approximately 7.5% allocated just to the precious metal.

Second, gold’s perception as a safe-haven also acts as a hedge during times of economic and geopolitical strain. Historical data suggests that the value of gold usually increases when there is a significant market meltdown. Even in those circumstances when gold also declined in value, it did so only marginally.

Finally, gold has low correlation with other asset classes. Since it is unlikely to move in tandem with stocks and beyond the macroeconomic factors aforementioned, it can provide well-needed capital appreciation. Accordingly, having gold in your investment portfolio increases diversification, lowers volatility, and consequently leads to higher-risk adjusted returns.

 

How to Invest in Gold?

The most obvious way to invest in gold is to buy the physical metal. In addition to providing the best price of gold (i.e. ‘spot’), it is likely the best option for those preparing for a doomsday scenario of systemic collapse. The disadvantage, however, is storage. Unless you are comfortable storing bullions at home, you will incur recurring fees for storage and insurance.

For the seasoned investor, you may also consider employing leverage via a futures contract. A futures contract is an agreement to buy or sell an asset at a specified price for delivery at a specified time in the future between parties, not yet known to each other. By using leverage, it is possible to gain exposure to the same levels of profit, and potentially loss, as if an investment had been made into the full value of gold itself. However, it is noted that futures contracts have expiry dates. This means an investor seeking to hold gold for a longer period will have to constantly reinvest in newer contracts that will likely be more expensive than the spot price of gold. Predictably, these rollover costs can rapidly accumulate.

For the everyday investor, investing in gold ETFs is probably the easiest and most practicable method. Gold ETFs track the price of gold by either holding physical bullions or by investing in gold futures contract. Unfortunately, this means such ETFs faces the same individual issues mentioned above, in addition to a small management fee (i.e. expense ratio). As such, gold ETFs may exhibit performance that slightly deviate from the actual price of gold.

Lastly, some may opt to investing in gold mining companies. The advantage is that many gold mining companies such as Barrick Gold provide periodic dividends to its shareholders. As a company however, their market value will often be more volatile that the metal itself since they are exposed to a wide range of idiosyncratic and systemic risks.

 

Concluding Remarks

We have explored the price drivers of gold, the reasons seasoned investors invest in it, and how you can purchase some gold for yourself. Do be mindful that the advantages for investing in gold could operate in reverse with the following two words of warning:

Whilst gold may serve as a good hedge against inflation, falling inflation rates can depress its value. By the same logic, rising nominal bond yields and a strong USD may also erode the value of gold.

Furthermore, although gold may leave you better positioned in times of market stress by offsetting the losses caused by stocks and bonds, the relationship does not always hold true during severe and often unanticipated market selloffs. This is because in stark times, investors may be required by brokers to increase the amount of equity for covering possible losses (i.e. margin calls), usually due to a losing trade. Such investors will often need to sell relatively liquid assets such as gold to meet the call, thereby depressing the metal’s value – at least in the short term.