Gold prices are testing historical highs as investors ponder the next move (see chart below). Several factors drive prices, some over the short term and others over the medium and long term. Factors driving gold’s price include supply and demand for the yellow metal.
Economic data and market sentiment will also drive the price during different periods, and the policies of central banks, inflation, and currency movements will also have an influence. Lastly, geopolitical and macro factors will generate both headwinds and tailwinds for the price of the precious metal.
While some factors like supply and demand will drive the price of gold over the long term, the issues tend to play out over an extended period. The part of supply and demand that plays a role over the medium term is the trajectory of the change in the dynamics. Over the medium term, the price is more of a function of economic data, monetary policy, geopolitical events, inflation, currency movements, and sentiment.
While many factors generate the price of gold, monetary policy from central banks is very influential. Monetary policies pursued by central banks, such as interest rate adjustments and quantitative easing measures, can impact gold prices. Lower interest rates and expansionary economic policies tend to increase the appeal of gold as an alternative investment.
What is Monetary Policy?
Central banks use various tools and strategies to implement monetary policy. They can change short-term interest rates to influence borrowing costs, investment levels, and consumer spending. A decrease in interest rates encourages borrowing and spending, stimulating economic activity. Conversely, increasing interest rates can help control inflation and prevent excessive borrowing and lending.
Central banks often set reserve requirements, the minimum proportions of customer deposits that banks must hold as reserves. Adjustments to reserve requirements affect the amount of funds available for lending and impact the money supply in an economy.
The banks buy or sell government securities and bonds in the open market to regulate the money supply. Purchasing securities injects money into the economy, while selling them withdraws money.
During periods of economic downturn or financial crisis, central banks may engage in Quantitative Easing (Q.E.). This activity involves purchasing large quantities of long-term government bonds or other financial assets to inject money into the economy and lower long-term interest rates. Central banks communicate their future intentions regarding monetary policy, interest rates, and economic outlook to influence market expectations and guide economic behaviour. Monetary policy can impact the currency markets as well as gold trading.
How Does Monetary Policy Influence Currencies?
Central bank policies can have a significant impact on currency markets. The actions taken by central banks to control monetary policy can directly affect exchange rates and the value of a country’s currency.
One of the primary tools used by central banks is adjusting interest rates. Higher interest rates tend to attract foreign capital due to the potential for higher returns. When a central bank raises interest rates, it can strengthen the currency by increasing demand for that country’s assets. Conversely, lowering interest rates can decrease the attractiveness of a currency, potentially leading to depreciation.
Central banks in different countries may pursue divergent monetary policies depending on their economic conditions. If one bank tightens monetary policy while another remains accommodative, it diverges interest rates. This scenario can influence investors to move their funds to a country with higher interest rates, driving its currency higher in value than other currencies.
When a central bank implements unconventional measures such as Quantitative Easing. or large-scale asset purchases, it increases the money supply in the economy. This activity can lead to currency depreciation as the increased supply reduces its value. Additionally, if a country’s bank purchases foreign assets as part of its Q.E. program, it can indirectly weaken its currency by selling it to buy foreign currencies.
How do Currency Movements influence Gold?
The value of gold is denominated in a currency, typically the US dollar. As exchange rates fluctuate, the price of gold in different currencies can change accordingly. A stronger domestic currency can make gold relatively cheaper, while a weaker one can make it more expensive.
Gold is often considered a safe haven asset during economic uncertainty or market volatility. When there is a decrease in confidence in a particular currency, investors may seek the stability and perceived value of gold. In such cases, the demand for the metal may increase, leading to higher prices.
The precious metal is also often regarded as a hedge against inflation. When a currency experiences inflationary pressures or is devalued, the purchasing power of that currency decreases. Investors may turn to gold to preserve their wealth and protect against inflation. In such situations, the demand for gold may rise, driving its price.
Interest rate differentials between countries can influence currency movements and impact gold prices indirectly. When there is a higher interest rate in one country compared to another, investors may engage in carry trades. A carry trade involves borrowing a low-interest-rate currency and investing in a higher-yielding asset, potentially leading to a currency depreciation. Changes in interest rates and associated trade activity can indirectly affect the demand for gold.
The monetary policies pursued by central banks, such as changes in interest rates or currency intervention, can impact currency movements and subsequently influence gold prices. Central bank actions that affect the value of a currency can have spillover effects on gold prices.
Market Expectations and Forward Guidance
Central banks often communicate their future policy intentions through forward guidance. If a bank signals that it plans to raise interest rates or tighten monetary policy, it can strengthen the currency as market participants adjust their expectations and invest accordingly. Conversely, if the bank indicates a more dovish stance, it can weaken the currency.
Central banks can intervene directly in the foreign exchange market by buying or selling currencies to influence their value. If a central bank considers its currency overvalued or undervalued, it may intervene to counteract movements it deems undesirable.
Economic Data
Economic indicators and market sentiment can significantly impact gold prices. For example, economic growth, interest rates, inflation, and currency exchange rates can influence investor sentiment and the demand for gold as a safe haven asset. Uncertainty or geopolitical tensions may also drive investors towards gold as a hedge against volatility.
Geopolitical events, such as wars, conflicts, and political instability, can increase the demand for gold as a safe haven asset. Macroeconomic events, such as recessions or financial crises, can also impact gold prices as investors seek safe assets during economic uncertainty.
The Trajectory of Supply and Demand
The balance between the supply and demand for gold plays a significant role in its price. Supply factors include mining production levels, central bank purchases or sales, and recycling activity. Demand for gold can fluctuate based on factors such as jewellery manufacturing and industrial demand, investment demand, and central bank demand.
Analysts determine the trajectory of supply and demand by collecting and analysing relevant data, utilising various research methods and models.
Some Common Approaches Used by Analysts
Market analysts gather data from multiple sources, such as industry reports, government publications, trade data, surveys, and financial statements. They collect information on supply and demand factors, including production levels, inventories, consumption patterns, economic indicators, and market trends.
Analysts may conduct market research and surveys to gather insights from industry participants, consumers, and businesses. This qualitative data provides valuable information about preferences, trends, and future expectations, which help determine the trajectory of supply and demand.
Econometric models to estimate and forecast supply and demand are often used by analysts. These models examine historical relationships and correlations between factors and use statistical techniques to project future trends. Econometric models may incorporate GDP growth, population growth, income levels, and price elasticities to derive forecasts.
Analysts also develop scenarios based on assumptions and potential future developments. By considering multiple scenarios, they can assess the potential impact of various factors on supply and demand and determine possible trajectories. They may combine their quantitative analysis with expert opinions from industry specialists, economists, and relevant experts. Expert insights can provide invaluable qualitative information and help validate or refine the quantitative analysis.
Analysts consider global and regional economic, political, and social factors influencing supply and demand. These factors could include changes in government policies, trade agreements, geopolitical tensions, weather conditions, technological advancements, or changes in consumer behaviour.
The Bottom Line
The upshot is that several factors drive gold prices over the medium-term. Supply and demand trajectory and monetary policy play a significant role in valuing gold. The difference in interest rates between the dollar and other countries catalyses the exchange rate of the dollar and the price of gold, which is usually quoted in US dollars. One of the most significant currency market drivers is monetary policy, specifically in the United States. Therefore, the Federal Reserve’s monetary policy activities are some of the most influential drivers of gold prices over the medium term.
