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The Price of Gold: Demystified by Philip N. Diehl

John-Rothans

Written by Philip Diehl

May 20, 2016

Gold prices seem to move in mysterious ways, but over the long term, a few forces account for most of these price changes. For those of us who buy gold and and hold onto it for a year or longer, these are the most important factors to bear in mind as we make our financial plans.

Factors Impacting Price of Gold

The value of the dollar

The value of the dollar against other currencies is important because gold is priced in dollars over the world. When the dollar is weak, gold is cheaper to purchase in other currencies. Since more than half of consumer and investor demand for physical gold comes from China and India, the relationship between the dollar and the Chinese yuan and Indian rupee is an important factor in driving demand. Chinese and Indian consumers have deeper cultural ties to gold than we do in the West, and as the middle classes in China and India continue to expand rapidly in the future, demand for gold in the world’s largest markets will grow rapidly.

Interest rates

The effect of interest rates on gold has been demonstrated dramatically over the past three years. The recent bear market in gold began in earnest three years ago when speculation mounted that the Federal Reserve was preparing to end its Quantitative Easing (QE) policies. That speculation was unfounded (or at least very premature), but the expectation that the Fed would eventually raise rates hung over gold markets, suppressing prices for more than three years, until the Fed finally raised rates last December.

Three weeks later fear gripped world markets when investors woke up to the global implications of a slowing Chinese economy. Uncertainty about economic conditions in the U.S. and Europe has mounted as well, and the Fed has cut back its plans for raising interest rates this year. In response, gold has rallied.

Lower interest rates reduce returns from high-quality (low-risk) bonds and other assets that compete with gold, which offers no return. When interest rates approach zero, or go negative as they are now doing in some economies, money flows from bonds into gold, raising gold prices.

Gold bugs have focused on the threat low interest rates pose for high inflation. For now, this concern is misplaced. Deflation, not inflation, is the major economic threat the U.S. and the world faces today and for the foreseeable future. The low interest rates now being used to fight deflation will continue to support higher gold prices for the next several years.

Economic and political turmoil

For hundreds if not thousands of years, gold ownership has been a tried and true way for individuals to preserve wealth in the face of political and economic uncertainty. When high inflation, financial crises, and depressions strike, people turn to gold for protection. The same is true when societies experience political instability. When turmoil threatens to spread globally, gold prices can rise sharply, as they did in the months after the September 11 attacks and following the 2008 financial meltdown.

However, sometimes gold does not respond when global turmoil strikes. Typically, this happens when investors flee riskier investments for the protection of safer, dollar-denominated assets rather than gold. The dollar and gold compete in this “flight to quality,” and gold can lose out when economic and political conditions in the U.S. are better than they are elsewhere in the world.

Central banks

For decades prior to 2009, central banks were significant net sellers of gold, dumping supplies on world markets and suppressing prices. Only two years later, the situation had reversed itself, with purchases by central banks in East Asia, India, Russia, and the Middle East turning the banks into major net buyers of gold. This trend has continued into 2016 and is expected to strengthen for the indefinite future.

The reason for this trend goes back to the value of the dollar. Most analysts expect the dollar to weaken against foreign currencies over the long term. The vast majority of these banks’ reserves are held in dollar-denominated assets. In order to protect the value of their reserves, the banks are gradually reducing their dollar-based assets and buying gold. But they must do so slowly to avoid crashing the markets they’re selling into, thereby destroying the value of their reserves.

Critics of gold, and central banks that buy and sell gold, often point to the poor timing of the banks’ purchases and sales, but their criticism is misplaced. Banks acquiring gold today are buying for the long term. Yes, their heavy buying began at the top of the market in 2011, but they've kept buying as prices have fallen, so the average price of their acquisitions are well below the peak. And the banks are not looking to sell anytime soon. They’re buying for long-term strategic reasons—to protect their nation’s wealth.

There’s a lesson here for the rest of us.

Exchange Traded Funds (ETFs)

Gold ETFs were a financial innovation (a derivative) designed to allow rapid trading in gold by bringing liquidity to the market matching the ease of trading paper assets. ETFs began to take off a decade or so ago and brought tremendous new demand to the market, contributing to the run-up in gold prices to their peak in September 2011.

But what ETFs giveth, ETFs taketh away. When the market turned south, the liquidity ETFs brought to gold triggered a rush to the exits, and many short-term investors in gold were crushed at the door. ETFs continued to reinforce falling gold prices over the next two years and have brought new, probably permanent, volatility to the market. Now, as prices have jumped this year, ETFs have returned to the market, and their buying is supporting the emerging bull market in gold.

ETFs were designed for highly sophisticated investors to profit from price volatility, not rising prices. This is unsafe territory for individual investors seeking wealth insurance and price appreciation in physical gold. Buyer beware.

Falling gold mine production and rising costs

Simply put, gold is getting harder to find and more expensive to mine. The cheap gold is already out of the ground. Moreover, gold mining is moving from countries that are friendly to the West and politically stable, to countries that view us more skeptically and are marked by political, economic, and labor conflicts. As a result, supply interruptions are more likely, and risk premiums are higher and rising, contributing to rising prices.

Also, the sharp fall in prices since 2011 has crippled mining companies. Bankruptcies have been limited so far as gold miners have slashed costs and capital investment budgets while consuming cash to stay solvent. Higher gold prices in 2016 are just a reprieve for many miners that can play this game for only so long.

Investments to raise mine output require years to bear fruit, so slashed capital spending budgets mean mine production will continue to fall for years to come.

  • In summary, I expect six of the forces I’ve described to fuel a long bull market in gold:
  • Falling value of the dollar
  • Exceptionally low interest rates
  • Growing middle classes in Asia and India
  • Increasing political and economic turmoil in the world
  •  Rising demand for gold from central banks
  • Falling mine production and rising costs and risks

But prices are likely to remain volatile throughout the rally as the dollar rises and falls, political and economic crises ebb and flow, and traders use ETFs to speculate on short-term price movements. For those of us who buy and hold for the long term, it’s best to put our gold in a safe place and ignore the volatility.


Philip N. Diehl is the President of U. S. Money Reserve, Inc., a former chief of staff of the U.S. Treasury, and 35th Director of the U.S. Mint. The views expressed in his blog are those of the author, and not necessarily of the company.

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