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Soap Box: What drives the gold price?

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In response to the tragic events leading up to civil unrest in the US last week, the US dollar gold price rose by 0.9% on Monday 1 June to above $1,741 a troy ounce. For Michael McCarthy, chief strategist at CMC Markets, one reason was clear: “concerns about the unrest in the United States at the moment appear to be weighing on market sentiment,” Reuters quotes him as saying.

Uncertainty coupled with fear underpins a higher gold price. The reverse is true too. When the world feels more at ease with itself, gold’s price drops.
Yet the relationship between fear and the gold price is, like all quasi-emotional links, indirect.

It’s difficult to recall now how shattering was the news of the terrorist attacks on the Twin Towers in New York on 9 September 2001.

One metals’ analyst described the situation that day as “complete pandemonium”.

Yet the gold price responded fairly calmly, going up (as measured by what was then the world benchmark, the twice-daily London fix), by almost 6%, from $271.40 in the morning to $287 in the afternoon.

Gold analysts are as prone to hysteria as the rest of us. The ‘pandemonium’ of that day did not register that much.

A jolting spasm in world affairs is not enough in itself to drive the gold price higher. Context is everything.

Back in 2001 the world was emerging from a lengthy period in which massive gold sales by the world’s biggest gold holders – central banks, closely tied as they are to governments – had been net sellers of gold. Switzerland had led the way by selling 1,550 tonnes of its gold reserves (more than half the total) from 2000.

The relatively weak gold price during the 1980s and 1990s encouraged gold mining companies to sell forward, to lease, their gold to bullion banks. Gold that was not yet dug out of the ground was sold forward to banks in a process known as hedging. These banks then lent the gold to whoever they liked, for a small interest payment. During the long bear market, when gold experienced a prolonged price deadline, that felt like a win-win situation – the gold miners, who expected the future price of gold to be weaker, made more money than they hoped, and the banks made a bit of interest on the lent gold. But this created a paradox of perpetuating the low price.

The gold price has recovered significantly since 2001 and hedging by gold miners has largely dried up. Thanks to the low-to-zero global interest rate environment we are living in, banks do not make money from gold leasing. Also, gold miners have stopped their hedging because the price of gold has been going up. Why sell ounces that are still in the ground at today’s prices, when tomorrow’s price may well be higher?

Many other factors underpin the gold price. Are central banks (the US holds more than 8,000 tonnes) buying or selling gold? Since 2010 they have turned from net sellers to net buyers.

In India, with some 10 million weddings annually, gold is sought after as part of the country’s traditional dowry practice. India typically buys (and stores) a lot of gold, held against a rainy day.

Demand for physical gold has slumped in the past few weeks, hit in part by the high prices and partly in India because the government more than doubled (to 3%) the tax on gold. India’s gold imports in May this year collapsed by 99% (compared to the same month in 2019) because the country has been in ‘lockdown’. The US dollar price of gold in May we should note started the month around $1,700 per troy ounce, slipped a little by 7 May, peaked at $1,764.01 per troy ounce on 18 May, fell again to around $1,700 by 27 May and is now back at above $1,743. This is an astonishingly strong performance during a month when the world’s biggest gold consumer halted its buying.

As any chart of the long-term gold price shows, gold has been since 2002 in a strong bull market, with the price steadily rising. Will it continue to rise? There cannot be any certainty. All that can be said is that the world, which has introduced unprecedented economic stimulus packages worth trillions of dollars – all borrowed money – is experiencing enormous political and monetary uncertainty.

If one is looking for a reason to get a Glint card and put some gold on it, there can be no stronger justification than the example of what’s going on right now – while India stopped its gold buying, the gold price stayed close to its all-time peak in US dollars.

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