Market Commentary 04 Oct 2018
Gold is one of the oldest means of exchange known to us and has played the role of currency for a very long time. While other currencies have taken over this role, the correlation between modern money and gold is not lost.
After the collapse of the Gold Standard, the US dollar became the de facto benchmark pricing mechanism for gold and international trade. Consequently, the two are very closely related. So, let’s look at how the US dollar impacts gold prices.
Gold is a versatile asset, and its price is sensitive to the overall perceived value of currencies worldwide. During times of fear or geopolitical turmoil, the price of gold tends to rise- much like it did due to US-China trade tensions in July. However, soon after in August, gold saw a 20-month low despite these geopolitical tensions. And the most important factor behind this has been the strengthening of the US dollar. But it’s not the first time that gold’s value has fluctuated because of a strong dollar or the US economy.
The value relationship between the dollar and gold is important, but the dollar isn’t the only factor that affects the price of the metal. Since gold does not yield interest in itself, it competes with interest-bearing assets for investment demand. When interest rates rise, the price of gold tends to fall, as the demand for other assets increases thanks to the higher returns that can be earned due to the higher interest component.
So, let’s understand in more detail how the dollar affects gold prices. The US official reserves hold a major chunk of all the world’s gold, despite not being the chief producer. It holds this position by importing most of its stock.
When the dollar is weak, importing gold becomes more expensive. Thus, companies have to pay more dollars to import goods and services, and dealers in bullion – as well as the government – also need to pay more for gold. This results in a rise in the price of gold. Conversely, strengthening of dollar means a drop in the price of gold.
A weaker dollar also affects foreign holders of US debt, which in turn undermines faith in the US Treasury and the economy. Declining faith in the US economy tends to raise the price of gold
Similarly, falling value of the US dollar could quite possibly be a symptom of monetary inflation. People tend to turn to gold as a safe haven when paper currencies appear under threat. Rising inflation is good for gold prices, and the inflation-adjusted price of gold could very well be positive if faith in the economy erodes. The subprime crisis of 2008 is a case in point. During that phase, the real estate meltdown and huge sell-off in equities saw a quantum shift towards gold, seen as a safer bet. In fact, during that time the positive impact of the crisis on gold prices was quite pronounced, and the metal achieved a historic high of about $1,900 an ounce.
Indian consumers view gold as both an investment asset and for adornment. For more than three-quarters of the Indian population, being a secure investment is the key factor for buying gold, while the rest cited adornment as the primary reason behind their purchase decision.
The relation between the rupee and the dollar plays a major role in the price of gold in India, though it has no impact on the global price of gold. Demand in India far outstrips the local supply; so much of the annual gold demand is met through imports. If the rupee weakens against the dollar, one needs to pay more in rupees to match the dollar price.
In a nutshell, appreciation or decline in the value of the dollar continues to influence the global price of gold in the opposite direction. While the US dollar is not the only factor that affects the price of gold, history has it that during times of inflation when the US dollar isn’t performing well, gold tends to be a safe haven for investors.