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Home » Whither Goes the Price of Gold?


KUALA LUMPUR, The Edge Malaysia, 2 February 2017 – A question many investors ask is: What drives gold prices? Ben Bernanke, former chairman of the US Federal Reserve, famously told the Senate Banking Committee in 2013 that “no one really understands gold prices”. He added that he did not understand gold either. For good measure, his successor, Janet Yellen, echoed his sentiments at her Senate confirmation hearing when she said, “I don’t think anybody has a very good model of what makes gold prices go up or down”.

On the other hand, there are many investment analysts who try to bring an understanding to gold prices. They typically see relationships between gold and one or more of the following economic and financial factors — the US dollar, oil prices, inflation, interest rates, equity markets, supply and demand for physical gold and geopolitics. Thus, the gold market is complex and the underlying data are the best estimates and subject to revision as new information comes to light.

Perhaps an explanation of how gold is traded will shed some light on price movements. Each day, gold is bought and sold in over-the counter (OTC) markets around the world — practically 24 hours a day, except for a 50-hour window over the weekend. Trading starts on Sunday at 6pm EST, when the Japanese market opens, and ends on Friday at 4.30pm EST, when the US market closes. Trading is continuous throughout the day, except for a 45-minute period (from 5.15pm to 6pm EST). In contrast, stock exchanges have official trading hours and closing prices.

The OTC markets are complemented by other gold markets around the world, including exchanges where derivatives such as futures and options are traded, and the swap market, which further augments available liquidity by enabling investors to borrow and lend gold.

The symbol for the intra-day spot price of gold is XAU. The best way to describe this spot price is that it is a theoretical price upon which all gold business is based. It is a base price that excludes commissions, fees and costs such as minting, insuring and shipping.

Each market reacts to news as it happens and prices are influenced by a myriad of players — investors, central banks, governments, miners, jewellers, dealers and producers. The World Gold Council (WGC) has estimated that the investable gold market is about US$2.4 trillion, which makes it larger than all the sovereign debt markets, apart from the US Treasury and Japanese government bond markets.

Additionally, if the foreign reserve holdings of governments were broken down by issuers, gold would be the second largest reserve asset in the world. In terms of daily trading volumes, the WGC has conservatively estimated that the average volume is at least US$67 billion, which is second only to the US Treasury bond market and larger than the UK gilt and German bund markets combined. The characteristics of the gold market have made it one of the largest and most liquid markets in the world.

I believe that gold’s unique characteristics make it the perfect diversification asset with an “asymmetric” behaviour against most other asset classes. In other words, during normal market conditions, gold price movements are generally uncorrelated to other asset classes. But in times of abnormal market conditions, gold tends to have a negative correlation to other asset classes. That said, if I were forced to choose only one factor to “explain” gold prices, I believe the changes in real yields* would be the most suitable explanation.

Gold is as an asset with no risk of default — it has no credit risk and has a real value that changes over time at a relatively constant level. In other words, gold maintains its purchasing power over the long term. The value of gold will likely vary over time with the level of real yields available in high quality, nearly “default-free” assets such as Malaysian Government Securities.

So, when the real yield on Malaysian sovereign debt is high, investors are likely to demand a bigger discount to the long-term estimated real value of gold. Conversely, when real yields are low, the opportunity cost of owning gold drops and investors pay a higher price relative to gold’s long-run estimated real value. If we abstract away from the statistical significance of the result, our results may indicate that a 100 basis-point increase in 10-year real yields on average leads only to a 2.52% decline in real gold prices.

At its core, long-term increases or declines in the gold price reflect a broader set of anxieties, such as global or domestic politics, the value of money or the outlook for other asset classes. People tend to see gold as a form of financial insurance and the cost of insurance is, of course, highest when you most need it.

* The sample consists of 156 observations from various sources for the gold price and yields of 10-year Malaysian Government Securities between August 2003 and August 2016. For the more statistically inclined, a series of annualised real yields was constructed by subtracting the annual (consumer price index-derived) inflation rates from the annualised nominal 10-year yields. Then, the logarithm of the inflation-adjusted price of gold measured in ringgit was used as the dependent variable to be regressed on the real yield. It was observed that there was a lack of a statistically significant relationship between real yields and the inflation adjusted price of gold (the p-value of the estimated coefficient is 12.7%).

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