In our previous post, we went over the basic terminology you need to start trading and some parts of the user interface. Now, we want to introduce you to some of the dynamics of the gold market and explain the fundamentals of the gold market.
There are actually several different ‘trading strategies’ that you can use when trading gold, the two commonly known ones are:
- Fundamental Analysis – The idea behind fundamental analysis is that the price of gold is determined by the economic and financial factors. So, you have to study the overall market conditions to find out how much gold is supposed to be worth, you need to find out the intrinsic value of gold. Based on that value, you might either see if gold is currently cheap or expensive and make appropriate investment decisions.
- Technical Analysis – Instead of looking at the news, technical analysis means looking closer at the price data. For example, a trend strategy will basically follow the principle that if the market is going up, it will continue going up or vice versa. There are many different techniques here that we’ll cover in more depth in our next blog.
In the end, the price of precious metals is mainly determined by supply and demand. If nobody is buying, the price will go down until it is low enough that people are interested in buying it again.
The idea of fundamental analysis is that people look at the overall market conditions to see what they think gold is worth. There are of course an infinite number of factors that someone can look at but majority of the price movements are probably determined by a handful of things that we’ll cover below.
US Dollar
The first one that is very important is the US Dollar. When you see the price of gold anywhere, it is mostly quoted by USD / oz.
If the intrinsic value of gold doesn’t increase, but the dollar becomes more expensive, then the price of gold should go down. This is always a slightly confusing concept to grasp at first, it is probably simplest to understand with an example.
Let’s say you can buy 1 apple with $1. Now, if gold is $1800/oz, that means you can buy 1800 apples with 1 oz of gold. If the dollar becomes more expensive, then you can buy 2 apples with $1. But the real value of gold has not changed, so you can still buy 1800 apples for 1 oz of gold. But those 1800 apples are only worth $900.
We generally say that the price of gold is inversely proportional with the price of a dollar, meaning that if dollar goes up, gold goes down and vice versa.
Below you can see a chart of the general strength of value of the dollar (DXY) vs the price of gold.
Interest Rates
The interest rate or bond yield is the money that you ean by buying bonds. By buying a bond, you are lending for instance a $100 to a company or the government and in return, they promise to pay you back $102 after one year. In this case, the bond would have a 2% coupon.
There are 2 ways that this increase in interest rates affect the gold price. Firstly, if US interest rates increase, more people are likely to buy dollars. Because let’s say I am holding Euros, in order to buy a US bond, I first have to buy dollars, so the demand for USD increases. Hence, the price of gold will go down, as we discussed before.
Secondly, if you hold gold, unfortunately, you are not getting any interest payments. So, if the bond yields increase, more investors will sell their gold and buy bonds instead.
Therefore, similarly to the dollar strength, if yields increase, gold should go down. Again, let’s prove this by showing the yield of owning a 10 year US government bond (US10Y) compared to the price of gold.
Inflation
Another important, yet related factor, you should consider is inflation. Inflation measures how expensive overall cost of live is. The most ‘famous’ way of measuring this is the Consumer Price Index (CPI). The idea behind CPI is to simply go shopping in the supermarket and fill your basket with different things. Repeat this every month and just monitor how much you are paying.
What you might have noticed is that things tend to become more expensive. Surprisingly enough, that is actually a good thing. The opposite of inflation is deflation. If there is a deflation, then most people will not spend money today because whatever you want to buy will be cheaper tomorrow. So, most of the time when a country has deflation, this has the risk of turning into an economic crisis where people are afraid to spend money.
On the other hand, having a high inflation is also not great. Because let’s imagine you are getting your salary today, which you can use to buy 1,000 apples. By the time you go to the supermarket and try to buy those apples, they have become more expensive and now you can only buy 500 of them.
Instead, there is a golden middle way, and that’s why you’ll often hear about central banks trying to target a specific level of inflation.
The reason why people are interested in gold is because it is an inflation hedge. By this we mean that it generally goes up the same amount as inflation does. In one of our other blogs, we already mentioned the famous saying that you can always buy a nice toga with 1 oz of gold. Although I personally do not know any place where I can buy a toga, I can still buy a nice suit for 1 oz of gold…
Therefore, if inflation is high, people will generally sell their dollars and buy gold, meaning the price of gold goes up.
On the other hand, it is also interesting to look at a concept called the real yield of a bond. Imagine you bought a bond with a 2% coupon. At the end of the year, you’re happy with the extra $2 you get for every $100 invested. But if inflation is at 3%, you have actually lost money.
Before your investment, you could buy 100 apples. But now, with your $102, you can only buy around 99 apples because those have become more expensive. So, the real yield of your bond is actually -1%.
So, if inflation goes up, people will sell their dollars and bonds and generally buy gold.
Risk on / Risk off
Gold is also what they call a safe haven asset. It is something so integrated in our society that people feel safe holding it. Unlike shares in the latest tech company, you know that gold generally does well in an economic crisis. Below you can see what happened after the 2008 crisis and after the 2020 COVID crisis.
On the other hand, if the market is doing very well and people are keen to take risks, they might feel ready to buy that fancy tech stock instead of buying gold.
This concept is called risk on, risk off (or the more fun name would be RORO). If people are taking risk (risk on), gold doesn’t perform well. And if people are not taking risks (risk off), then gold performs very well.
There are many factors that might affect the risk appetite of investors. One example would be geopolitical factors. If a war breaks out, an oil platform is attacked, or the US applies yet another set of sanctions, people are afraid that a situation might escalate and therefore are risk off.
Another factor that is important too is market stability. During an economic crisis, people are not willing to take any risk. Or also during volatile times (where assets move up and down more than usual), investors might again not be willing to invest their money in more risky assets.
There are actually lots of interesting topics to cover on this aspect alone, which we’ll leave for a later blog posts.
Unfortunately though, the risk people are willing to take is not easy to measure or quantify. Therefore we often use proxies to estimate the risk. Generally, it is good practice to have an idea if we’re in a risk on or risk off environment, since it might have a big effect on your portfolio.
Central Bank Reserves
The largest owners or purchasers of gold are … central banks! US and Germany for example have massive supplies of gold. The United States alone has around half a trillion USD worth of gold deposits according to the World Gold Council. And Chinese, Russian and Japanese central banks are still buying large quantities of gold on a monthly basis
So, keeping an eye on those banks is often not a bad idea. If one bank starts buying up larger quantities, this will move the price up.
Gold Production
Finally, coming full circle, covering both the demand and supply side, we also have to talk about gold production. If more gold is produced, either more people will have to buy gold (increased demand), or the price of gold will go down.
Generally though, supply is relatively stable. This is because of the extremely large investments required to setup a gold mine.
Of course, there are several other factors that you could consider too, but the above does give a good first start of which fundamental factors to consider when making an investment.
You could actually solely rely on the above to run a successfull precious metals portfolio. But, at 24Gold, we are big believers in diversification.
Unfortunately no single strategy can explain all price movements, so we’ll cover another very important aspect in our next blog about technical analysis.
If you do require any information about the current market or want to get expert advice, do not hesitate to reach out to our excellent trading team to get you up and running.
