Gold is the most ancient legendary asset, humanity's curse and blessing. The precious metal that was once used as money but has lost its appeal in recent years. Loads of legends, fantasies, and rumours surround it. The asset that can both yield profits and cause disappointment. This article doesn't claim to be exhaustive, but we will try to find out what drives gold prices and who is responsible for the fluctuation of gold prices. Also, we are going to discuss how to earn and save money when buying gold.
The article covers the following subjects:
Dollar and gold as measures of value
What factors affect gold prices?
Gold market & Gold price trading economics: peculiarities of pricing and structure
Speculators: London versus New York and Chicago
Commodity Futures Trading Commission and Commitments of Traders Report
Dollar and gold as measures of value
Gold is a precious metal that once served as money, but in recent years has lost its former attractiveness. The equivalent of value around which many legends and unverified rumors revolve. Investing in this asset may be profitable or disappointing.
History and modern times
First, let's check the facts. As we know, the US dollar became the world's reserve currency at the international conference held in Bretton Woods, USA, in July 1944, when the Second World War was almost over. Thus, other currencies became pegged to the USD's value, and their rate was determined through the principle of parity. At the same time, the dollar was pegged to gold, whose price was set at 35 USD per troy ounce (31.1035 g). One gram of pure gold costs $1.125. Central banks maintained currency parity. However, in 1968, the Two-tier gold system was established, and the price of gold became dependent on demand and supply.
In August 1971, US President Richard Nixon decided to close the gold window and introduced a ban on USD-gold exchanges at an official bank rate. The dollar devalued as early as December of the same year, and the gold price rose to 38 USD. That meant the bankruptcy of the USA. Next, the USA devalued the dollar to $42.2 per troy ounce, and the golden standard era came to an end. Following the Jamaica Agreement in March 1976, the Forex market emerged, and the exchange rate system became floating. Still, the dollar remained the world's reserve currency, which allowed the USA to launch the printing press at its discretion later.
Forty-eight years have passed since then. One troy ounce grew in price to $1,475, an impressive growth by 42.14 times or 4,214%! However, few people think of investing and getting a return in 50 years. A closer prospect of 5, 10, or 20 years is more appropriate. And traders are interested in even shorter time frames: one year, one quarter, or even one month. So, what affects the price of gold, and how do we determine its direction? Let's try finding it out in this article.
What factors affect gold prices?
Let's take a look at the main areas of gold production and consumption, as well as analyze the supply and demand statistics.
When it comes to analyzing the price of gold, fundamental analysis is more pertinent than technical analysis. The law of demand and supply influences the price in the conditions of market price formation.
According to the World Gold Council's information (WGC), the primary demand sources are jewelry production, the technological sector, investment, and central banks (pic.1).
In 2018, jewellery production consumed 2,241 tons and technology - 335 tons. The investment sector bought 1,164 tons and central banks - 656 tons. Gold's new production amounted to 3,501 tons, and 1,177 tons were recycled. In 2018, the leading gold producers were: China (404.1 tons), Australia (314.9 tons), Russia (297.3 tons), and the USA (221.7 tons).
Pic. 1: Main consumers of gold
Based on the WGC's data, the leading consumer of gold is jewelry production with a 51% share. Also, we see that jewelry production has been the main buyer for many years. It's supposed to affect the gold price, but all isn't so simple. True, the gold price depends on the demand for jewelry in the USA, India, and China, but this dependence belongs to long-term factors. So does central banks' demand or growth of electronics production.
What drives gold prices?
I can single out four main categories of factors that affect the price of gold:
economic expansion and growth of well-being;
market risks and uncertainty;
alternative prices;
impulse and positioning.
The two first factors are particularly important to gold prices' long-term prospects. They form a basis for strategic reasons for buying and investing in gold.
There's a connection between the price of gold and economic expansion. Growth in people's well-being provokes a higher demand for jewelry. The technological sector demands more gold too. Inflation incites investors to invest money in gold and gold-containing assets. In the USA, India, and China, gold is an object of luxury and a store of value.
If a market, geopolitical, or any other risk arises, investors treat gold as a safe-haven asset that protects them from money devaluation. The price of gold is affected by central banks' policies and market positioning, leading to huge growth or fall of this precious metal's price.
There are multiple-factor models for assessing the prospects of gold. They allow forecasting the direction of the price with high precision. In such models, the price of gold is determined through the interactions of drivers. However, those models' complexity and the absence of reliable information prevent us from using them in everyday trading or investment solutions. There will always be unknown variables that may disprove a hypothesis and prevent the realization of a forecast. So, we need a simple tool based on some assumptions, which is likely to make the right forecast for gold in the Forex market.
Gold market & Gold price trading economics: peculiarities of pricing and structure
When trading commodities, it’s important to be aware of their demand&supply’s structure and dynamics. A typical example is oil, which is recovering lost positions by leaps and bounds amid expectations of growing demand and surplus reduction, as main global economies have started to reopen. Unlike Brent and WTI, gold is less sensitive to the physical asset market’s state. However, it can punish any time a trader who ignores fundamental analysis.
Jewellery production and investment prevail in the gold global demand structure. In 2019, they accounted for 48.5% and 29.2% of demand, respectively. Central banks’ share in gold purchases was 14.8% while industrial use accounted for 7.5% of gold consumption. The latter indicator is important. The thing is it is much higher for silver. The shutdown of industrial enterprises led therefore to a faster slump of XAG/USD if compared with XAU/USD. As a result, the gold-silver ratio soared to historical peaks. Against the backdrop of the recovering global economy, the ratio may be expected to drop. It means we’d better bet on silver’s faster growth against gold.
Dynamics of global demand for gold
Source: WGC.
The relative share of investment in the structure of the gold global demand grew up to 49.8% while the share of jewelry production dropped to 30.1%. Consumption of gold reduced almost in all sectors, except for ETFs and coins, as compared with October-December and January-March 2019.
Dynamics of quarterly demand for gold
Source: WGC.
A change in a demand structure is an important gold pricing factor. When it happens, we may say a current trend is stable. The shift from jewelry to investment is a clear sign of bulls’ market dominance. Jewelry is too expensive and its consumption is falling. On the contrary, the faster ETFs’ reserves grow, the higher their quotes are and the bigger their buying army is. They sometimes say gold flows from east to west in an uptrend. True, in 2019 the relative share of China and India in the jewelry’s gold consumption structure was 67%, while the main ETFs are located in the USA, including the biggest fund SPDR Gold Shares, and Europe.
The main producers of gold are China (404.1 t), Australia (314.9 t), Russia (297.3 t), the USA (221.7 t), and other countries. Supply’s influence on the price is limited. The year 2013 is a bright example. Many said then XAU/USD quotes couldn’t drop below $1,300-1,350 per ounce as it was gold producing companies’ break-even. They said production would be cut to provoke a deficit and price growth. But in fact, existing hedging technologies allowed companies to fix the price and continue producing the same volumes of gold. So, gold fell even below the expected levels and buyers were punished for their extreme self-confidence.
At the same time, supply shouldn’t be fully ignored. In 2020, investors felt a critical shortage of physical assets when trading forwards amidst the pandemic and shutdowns. As a result, gold premiums grew in the USA and Europe and XAU/USD quotes rose as well.
Dynamics of gold quotes in spot and forward market
Source: Bloomberg.
So, investment demand is an important factor in gold pricing. Its volume is mostly affected by central banks’ monetary policies. Massive monetary expansion contributes to weakening major currencies, dropping bond yield and raising XAU/USD quotes.
Speculators: London versus New York and Chicago
As I know from my practical experience, demand for so-called "paper gold" is the main source of demand for gold that affects its price. "Paper" gold means derivative instruments based on gold: futures in commodity markets and shares in ETFs. So, speculators influence the gold price the most, even if their share in global demand is relatively small in the short and medium-term (26%).
On the one hand, it's not suitable for investors who face various kinds of manipulations in the gold market. On the other hand, knowing that fact makes simple traders' life easier: they only have to follow Managed Money traders at Chicago and NY Mercantile Exchanges.
First, let's find out why the price of gold is formally determined in London, but practically - at COMEX in the USA.
For many years it's been assumed that London accounts for the highest gold trading volumes. That assumption wasn't confirmed because real information was classified as secret. In autumn 2018, the London Bullion Market Association (LBMA) published data on the gold trading volume first time in history. According to the data, the trade volume was 4696.7 tons the week of 16 November or 939.37 tons on average in daily terms. That volume was bigger than in Shanghai but yielded to the conglomerate of Chicago and NY.
Here's a comparison of actual trade volumes in London and New York. According to LBMA's information published on 16 December 2019, London’s trade volume amounted to 160 million ounces the week of 11 December 2019. If we translate it into a futures contract, it makes 1,600,000 contracts (See pic. 2) At CME-COMEX, the volume was 1,719,000 contracts, according to the stock exchange report over the same period.
Pic. 2: Weekly gold trading volume, LBMA
So, London's gold trade volumes are comparable with the USA and saying that London doesn't affect the price of gold would be a simplistic approach. Still, we can't do without some simplifications because we don't possess all the information on the parameters we are interested in. What's more, all the markets are interconnected; that's why a change in London's trades has an immediate impact on Chicago's trades, and inversely. However, we can find a very interesting correlation that can be used for analyzing the price of gold. We have to look at long positions of Managed Money traders at COMEX.
Commodity Futures Trading Commission and Commitments of Traders Report
The thing is that the price of gold correlates with the dynamics of long positions of COMEX traders (pic 3), and COMEX is accountable to the US Commodity Futures Trading Commission – CFTC. According to the CFTC's requirements, futures contract traders need to provide a Commitments of Traders Report (CoT) to the CFTC. So, we can get daily updates on traders' actions in gold futures contracts and make relevant conclusions by checking traders' positions in СoТ reports.
According to Commodity Futures Trading Commission's classification, gold is bought mostly using Managed Money in the futures market. If we look at diagram 3, we will see it is true. CME - COMEX's trade volumes are higher than or equal to LBMA's trade volumes. It means that the main buyers' higher demand for gold results in higher gold prices, and inversely.
Watching Managed Money positions is key to understanding what is going on in the gold market. These positions reflect a "collective mind" when every buyer acts based on his/her requirements, but together, they determine the direction of prices according to demand and supply.
Inexperienced investors have to deal with unverified or even false information daily, while numerous "experts" recommend buying this or that asset. They often do it deliberately to trap traders.
For example, George Soros spread rumours in 1993 saying that the Chinese government was buying gold. He urged investors to take advantage of that information. When gold reached its 10-year bottom of $326, Soros bought 10% of Newmont Mining Corp's stock, which raised the price to $414. Then the gold fever calmed down, and gold returned to a level of $361. It turned out later that Soros had sold gold at the peak, spreading rumours via the mass media.
These days, we can only dream of those prices, but it was no laughing matter for investors at that time. Analyzing big players' positions at CME-COMEX and capital inflows and outflows in futures contracts, you'll never be trapped by any "soroses" Have a try and trade gold at Forex!
Pic.3 Managed Money positions at CME-COMEX
As we can see in diagram 3, the gold price has been moving simultaneously with Managed Money long positions opened at CME - COMEX. To persuade skeptics that it's speculative buying at the futures market and ETFs’ buying that influence the gold price in the short and medium terms, I'll provide additional "evidence" based on World Gold Council's Q3 statistics.
WGC's report as of 5 November called "Gold Demand Trends Q3 2019" says that
"ETF-backed holdings hit a new record of 2,855 t". They grew by 258.2 t up to their highest since Q1 2016.
Central banks increased their reserves by 156.2 t, which is a 38% fall y-o-y.
Jewelry demand dropped 10% to 460.9 t.
Bar and coin demand fell to 150.3 t.
Gold supply grew 4% to 1222.3 t.
Despite all those negative factors, the gold price continued growing in Q3 2019 and reached new multi-year highs. At the same time, the futures market registered a 3-year peak in Managed Money buying and a new capital inflow. The speculators' collective mind showed buyers' growing demand. Open Interest rose to historic highs, meaning that new investors came to the market to profit from the price growth. The rest of the factors, such as the growth in central banks' and jewelry demand, indicated a slowdown of activity. Even investments in physical gold dropped, and gold supply rose.
The World Gold Council's data prove that speculators' interest outweighed all the other factors, and the gold price updated its 6-year peak. The value of this knowledge is too high. By merely watching Managed money traders, we can get invaluable information. Analyzing this information, we can have an idea of what is going on in the gold market. This insider information can bring significant profits if appropriately treated.
Read the gold price forecast and prediction here.
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