What has taken the shine off gold?
Gold has captured the imagination for thousands of years as a signifier of wealth. Gold has motivated entire societies, determined the fate of kings and emperors, provoked acts of war and driven individuals to endure intense hardship in the hope of finding instant wealth. It has more recently provided a function in financial markets as a store of value when other asset types, such as equities, currency or property, risk losing their value.
The Bank of England and US Federal Reserve have recently alluded to raising interest rates in the near future on the back of improving UK and American economies. Currently the interest rate set by the Bank of England is 0.5% and the US interest rate is 0.25%. Mark Carney, the governor of the Bank of England, has signalled that UK interest rates could begin to rise around the beginning of 2016, if not earlier, and US Federal Reserve chairman Janet Yellen has suggested that US interest rates are likely to rise by the end of the 2015, although both of these projections may be subject to change given the turmoil in global financial markets over the last week.
Even though gold is seen to be a store of wealth for investors, it generates no returns from regular interest payments or dividend income. In a time where returns are low for investors due to suppressed interest rates, investors had been satisfied to invest in gold while the economic backdrop has remained volatile. But, with borrowing costs set to rise, commodities, such as gold, are losing favor with investors as higher returns may be available elsewhere.
The US dollar has been growing stronger, boosted by a growing US economy and the prospect of a rate rise in the next few months. The US dollar index, which tracks the price of the US dollar against the world’s currencies, has increased by more than 20% within the past year.
The value of the US dollar typically follows an inverse relationship with commodities. When the dollar strengthens against other major currencies, the prices of commodities - such as gold - typically drop. When the dollar weakens, commodity prices generally move higher. The main reason for this is that most commodities are freely traded in international markets and prices are quoted in US dollars. Foreign buyers will purchase commodities with dollars, so, when the value of the dollar drops, they will have more buying power, and demand for commodities may increase. Similarly, when the value of the dollar rises, they have less buying power and commodities become more expensive, muting demand and sending commodity prices lower.
For generations people have turned to gold to store their wealth in times of crisis. The recent crisis in Greece has created uncertainty in world markets but a makeshift resolution agreed between Greece and its creditors seems to have eased concerns that the struggling state will leave Europe. Greek banks have recently reopened after a third bailout package was agreed and extended a €7bn bridging loan for a country starving for liquidity. As fears over the collapse of the Eurozone recede, investors are once again more comfortable holding riskier assets that provide the potential for better returns.
The world’s largest consumer of commodities is China. The Chinese economy had been displaying a gradual slowdown since 2010, with headline Gross Domestic Product (GDP) growth falling from 10.6% to 7.4% over the period. The People’s Bank of China has recently declared that it has been buying far less gold than expected and will continue to limit the amount of gold they will purchase. This fall in Chinese demand has inevitably led to a lower gold price, and there are concerns that demand from China will continue to slump as their domestic economy stutters.
The demand for gold, the amount of gold in the central banks' reserves, the value of the US dollar and the desire to hold gold as a hedge against inflation and currency devaluation, all help determine the price of gold.
The drop in gold prices can be seen as a sign of economic security. Gold is a market just like any other, driven by supply and demand, but the price of gold is also determined by investor sentiment. In the aftermath of the economic crisis in 2008, gold enjoyed strong increases in price. As the banking crisis unfolded, many investors rushed to the safe haven of this asset class. Investors are now choosing to invest elsewhere, which demonstrates confidence in other asset classes, reducing the demand or requirement for traditionally secure assets. The prospective rise in US interest rates stimulates confidence that the US may continue to improve and the third Greek bailout gives more confidence in the Euro and the European economy.
Viewing the historic price of gold it can be said that high gold prices have been associated with economic unrest, and low prices with calm and prosperity. Warren Buffet once said, “Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head”. The investment of gold continues to divide opinion like no other.