Of all precious metals, Gold is the most popular as an investment. Investors generally buy gold as a hedge or harbor against economic, political, social and currency crises (including investment market declines, escalating national debt, currency failure, inflation, war and social unrest). The gold market is subject to speculation as are other markets, especially through the use of futures contracts and derivatives. Gold prices lack the strong link to the economic cycle that other commodities have and gold has thus often exhibited low or even negative correlations with these and other financial assets. That’s why price chart of Gold has shown tremendous strength in past few years.
Demand & Supply
Since April 2001 the gold price has more than quintupled in value against the US dollar, hitting a new all-time high of $1,913.50 on August 23, 2011. Today, like most commodities, price of gold is driven by supply and demand as well as speculation. However unlike most other commodities, saving and disposal plays a larger role in affecting its price than its consumption. Most of the gold ever mined still exists in accessible form, such as bullion and mass-produced jewelry.
Impact of Inflation & Interest Rates
The actual factor that influences gold prices is the level of real interest rates. As gold lacks yield of its own, the opportunity cost of holding gold increases with a real interest rate hike and decreases with a fall in the real interest rates. Periods of negative real interest rates ought to be positive for Gold, and this contention is supported by studying the 1970s when real interest rates were substantially negative for lengthy periods. More recently, the short-term rates near zero combined with modest inflation have also implied mildly negative real rates and have supported the demand of gold.
Role of Central Banks
The behavior of central banks has an important impact on gold prices. A major reason is that central banks are big holders of gold, possessing some 30,500 metric tons in 2010, which is approximately 15% of all above-ground gold stocks. As a result, central bank policies on gold sales and purchases can have significant effects, and these policies have been subject to considerable shifts over the decades.
Shift in Global Economic Strength
Currently, the world economy faces concerns over sovereign creditworthiness, the impact of loose monetary policy including quantitative easing on medium-term inflation, and possible effects of unrest in the Middle East on global oil markets. There are also long-term structural issues looming large such as the future of the US dollar as a reserve currency and the ongoing shift in the balance of economic power and wealth from the western developed countries to the rapidly growing emerging economies such as China and India.
Since 2007, the world has seen a period of striking economic and financial volatility, featuring the deepest recession since the 1930s and steep declines in the value of many financial assets – both traditional ones such as equities and newly developed ones such as mortgage-backed securities. Against this background, however, gold has performed strongly with its price roughly doubling since the global financial crisis began in mid-2007.
A significant and commonly observed influence on the short-term price of gold is the level of financial stress, which has led to gold sometimes being described as ‘a crisis hedge’. In periods of financial stress gold demand may rise for a number of reasons:
Steep declines in the value of other assets such as equities and high volatility of asset prices, leading to demand for a more stable store of value uncorrelated with other assets.
Fears about the security of other assets such as bonds due to the possibility of default, and even fears about cash if the health of the banking system is in question. The need of liquidity in an environment where it may be difficult to realize the full value of other financial assets
These considerations collectively explain why gold’s use as an investment vehicle appears to be rising, with investment driven demand up to around 40% of the total in 2010 from less than 15% in 2002. With central banks becoming net buyers of gold in 2010 for the first time since the late 1980s, there seems to be evidence of a reappraisal of gold’s value by various classes on investors. As a result, gold could peak at levels even higher than the ones seen last year.