For us, gold and silver are the most complicated assets to price. Stocks, currencies and other commodities mostly depend on fundamental data of the stock, the country or on physical demand and supply of the commodity. Once fundamental data about the asset comes out, even an inexperienced investor can understand most price movements.
Pricing gold or silver on a fundamental basis is far more difficult because prices depend on the valuation of other assets and on differences between U.S. data and the rest of the world. We think that gold and silver are valued somehow “indirectly”, it is a relative valuation and describe a “delta” between the US and the rest of the world. This makes trends driven by fundamentals very difficult to understand. Maybe therefore, gold and silver are far more subject to “love it or hate it”.
Many analysts base their arguments to buy or sell gold on a limited set of fundamentals or only on technicals. Many gold bulls based their analysis mostly on the explosion of public debt and/or on real interest rates. Since these bulls do not get the fundamentals right. In 2013/2014 they got caught on the wrong foot and consequently they speak about conspiracy theories and market manipulation when the gold price falls. Many opponents, however, argue that gold brings no income, but has only a cost of carry. We will see that this opinion is also ingenious because in certain periods, gold prices increase far more quickly than the total return on stocks or bonds including dividends and coupons. For us:
To grasp this sentence more easily we determined six major fundamental drivers for gold and silver:
- Price movements of other commodities in combination with global demand for these commodities, an “indirect pricing” of production costs.
- Global and in particular U.S. inflation, often driven by rising money supply
- Trade imbalances and U.S. debt and the U.S. twin deficits, that might culminate in a “fear factor”.
- Central banks’ activities like money printing or gold purchases and sales.
- Real interest rates and in particular the ones in the U.S.: interest rates compared to inflation and wages
- Private physical demand and supply.
Technical support and resistance levels might be more important for gold and silver than for other assets because fundamentals are difficult to understand.
1) Gold and silver move with other commodity prices and global growth
Gold and silver are correlated to other commodity prices. In particular the global Brent oil benchmark and copper, in the last years a proxy for Chinese investments, are closely linked.
Gold, copper, zinc prices compared (source)
Recent developments (2013/2014):
Higher supply of U.S. oil and slower global growth weakened oil prices and consequently gold prices. Both copper and oil got under pressure by the slowing of Chinese real estate investments. High Chinese interest rates (see also the next point) and the regulation of Chinese housing, where the law disallows to buy a second home, helped to calm these investments.
2) Gold and silver prices are correlated to global money supply and inflation.
Metals appreciated until 2011 with rising money supply and inflation in emerging markets:
Due to the high portion of food and energy in these countries’ CPI baskets, the effect of rising commodity prices on inflation is stronger than in developed nations. Since summer 2011, but also between spring 2008 and autumn 2008, global inflation figures fell and consequently also gold and silver prices. The following chart shows the relationship with the yearly change of U.S. CPI inflation.
Gold versus US YoY CPI rate until summer 2011 (source)
These charts, however, show two measures of the CPI-adjusted gold price:
The common view that the gold price is related to U.S. inflation is difficult to sustain in a world where emerging markets soon achieve half of global GDP. During the end 1970s “gold bubble”, however, U.S. inflation was the main driver of high gold prices (see more under point 5).
Recent developments (2013/2014):
Tight Chinese monetary policy with Central Bank lending rates of 6% limited investments, while the end of U.S. tapering also indicated tight monetary policy, limited inflows into Emerging Markets (EM) and available money in these former drivers of global growth. Falling food and energy prices in Europe are an indicator of weak EM.
3) Gold and silver prices appreciate with trade and growth “im-balances” against the United States: the “fear factor”
Gold and silver typically rise together with economic improvements in emerging markets and (historically) Europe when the U.S. cannot cope with this pace. This imbalance leads to a “fear factor”, namely that suddenly U.S. consumers stop spending like they did in 2008.
Between 2009 and summer 2011 emerging markets continued their ascent but high oil prices and the weak housing market hampered the United States. A similar situation happened in the 1970s when Southern America and Europe showed far higher growth than the U.S.
While these improvements helped the oil price, the U.S. trade deficit increased. This resulted indirectly in higher US debt.
While the U.S. has high debt and trade deficits, countries like Germany or China exhibited current account surpluses and high savings. These must be:
- Either be invested in the local economy: investments in real estate or fixed assets boost commodity prices and via factor (1) the gold price.
- Or they must be exported with the financial account of the balance of payments: Central banks in EM often buy hedges against inflation, more in point 4.
If capital exports are smaller than the current account surpluses, then the currency is a rare good, it typically appreciates. When the yield of foreign investments is too low (see also factor 5), then surplus countries prefer to invest in the local economy, often in real estate to counter inflationary effects.
None the less, with rising wages and partly due to the stronger real effective value of the yuan, the Chinese current account surplus has considerably weakened. Recent data showed a Chinese trade deficit, even if distorted by the Chinese new year.
Stronger investments and real estate prices in the U.S., however, tend to weaken the gold price. Rather, they raise expectations of a US interest rate hikes (see point 5).
The graph above shows that the monthly U.S. trade deficit ex-petroleum has remained pretty stable around 25$ bil. US$ for 13 years, except some excesses before and some temporary improvements after the crisis. This implies that the U.S. trade balance is mostly dependent on supply and demand of oil (factor 1).
4) Gold prices are correlated to central banks’ activities
For decades central banks in Europe and Emerging Markets relied on buying US treasuries – often bought in times of lower U.S. inflation – or gold – in times of high U.S. inflation. The reason was that due to the potential of higher wage hikes compared to the richer Americans, the European or EM currency risked to depreciate for example in risk-off phases. This could again trigger inflation, higher wage demands, more inflation, and finally hyper inflation.
Hence holding U.S. treasuries or gold fulfilled a double advantage: the central bank had inflation-resistant reserves and could profit on an appreciation of the dollar or gold. Traditionally EM relied more on buying U.S. Treasuries. From the year 2002 on, however, most EM currencies improved against the dollar and destroyed big parts of their central banks’ profitability. This intensified after 2008 when the US treasuries yielded less than the high rates EM central banks had to pay on their deposits in order to prevent an overheating of their economies.
To avoid a potential bankruptcy, they bought more and more gold that – as we know – as inversely related to the dollar.
Between 2010 and 2012 more and more central banks in EM reduced their dollar share and bought gold instead. China holds 1.7% of reserves in gold, India 10%, Brazil only 0.5%. In particular, countries with current account deficits, like India (10% central bank gold holdings), Belarus (30%), Egypt (25%), often prefer gold to stabilize their currency, while Western central banks still stick with the former IMF rule not to buy gold any more.
The gold share of EM central banks is still relatively low today, whereas it is very high for many European countries. The reason is that the central banks of Germany, France and Italy (all three with 72% gold holdings, see the full list of global gold holdings) could build up their reserves during the Bretton Woods era. The following charts show the gold purchases of central banks and the increase of currency and gold reserves of emerging markets compared to US GDP.
Europeans filled up their gold reserves during the Bretton Woods system, due to rising U.S. inflation finally at a relatively cheap price.
In the Bretton Woods system, all other countries fixed their N currencies against 1 currency, the US dollar. The Fed was obliged to exchange one ounce of gold into 35 US$. This created a so-called N:1 currency system. The U.S. president Nixon closed this cheap gold at 35$ window in 1971.
With flexible exchange rates gold lost its status. The IMF demonetization of gold policy even urged central banks to sell their gold, countries like the UK and Switzerland followed these calls.
Today the Fed is still the leading central bank in an implicit N:1 system of central banks, sometimes called “Bretton Woods II”. A weak U.S. economy still urges the Fed to act within its double mandate of maintaining low inflation and reducing unemployment. The Fed often implements easing measures and expands its balance sheet. Typically gold prices rises and the US dollar weakens after this “quantitative easing”, because private investors and some central banks move out of the dollar into gold.
When, however, U.S. unemployments falls, then the dollar appreciates, money gets more tight and investors shun EM (see factor 2), oil and commodities prices fall because investments in particular in EM become more expensive (see factor 1) and with lower oil prices the US trade deficits diminishes (see factor 3).
Recent developments (2013/2014):
5) Gold and silver prices rise with falling U.S. real interest rates, with “financial repression”
Still today American funds are the most important driver of financial markets. Therefore gold and silver prices fall when for these investors U.S. treasuries become more attractive relative to gold or silver. In times of high real interest rates, the gold price is weak and vice verse.
The following graph gives a bit more differentiation. It shows periods when the simple relationship stipulated in this point gets overlaid
- by factor (1), the development of commodity prices and global growth – between 2005 and 2007 (despite positive real interest rates)
- by item (2), when inflation rose more quickly than rates – between 1977 and 1980 (despite slightly positive real interest rates).
The gold price falls when the U.S. economy improves and the chances of a Fed Funds rate hike increase, even if this hike is far in the future. Particularly when more U.S. jobs are created, then gold and silver prices decline.
Wages as underlying factor for interest rates and the gold price
During the 1970s, inflation expectations and consequently wages rose in response to oil shocks and rising oil prices. The gold price moved upwards together with wages and oil prices.
The Fed chairman Volcker finally hiked interest rates so that unions stopped higher wage demands, new supply (e.g. North-sea oil) suppressed the oil price and the incomes of emerging markets. Global growth was sluggish. Consequently the Fed managed to keep inflation under control, company margins and stock price rose again: The Fed destroyed the gold price.
In the year 2013, the opposite picture arrived: U.S. wages had been nearly steady for years, but company margins were increasing. The wage share of GDP is declining, while companies could profit on global supply chains and cheap labor in emerging markets. Leading economists like Paul Krugman, spoke out in favor of rising wages.
For us it implies that the Fed should continue to support gold prices.
6) Gold and silver prices move with physical supply and demand
Update 2013: Demand and supply for physical gold and silver diverted sharply.
The above five factors are certainly visible in the supply and demand situation for gold and silver, still price movements are often more reflected in modern instruments like ETFs and futures. ETFs made it possible that new investors were able to buy the metals more easily. With the resurgence of Asia after the crisis of 1998, gold and silver prices have seen a big bull run. One reason is that China and, even more, India have a strong gold and silver tradition and massively increased their physical purchases. The Indian savings rate is over 20%, a bigger part of savings move into gold.
Silver has more industrial use, often in emerging markets. Silver reacts more strongly to physical supply and demand than gold.
Other commodities, especially oil react very strongly to temporary disruptions of supply. This is not the case for gold: temporary disruptions like a strike of South African miners does not affect the price very strongly.
Newly discovered gold in California weakened its price in the 19th century. Silver appreciated with higher industrial use at the end of 19th century. Silver prices also rose with the switch of the Netherlands and India to silver-backed currency. As a consequence, some years later, cheaper gold and higher silver prices let many central banks switch from bi-metal or silver-backed currencies to gold-backed currencies, to the gold standard. The CEO of Barrick in a note to shareholders, said that:
In 2011, the company performed well against this strategy. Barrick met its operating guidance for the ninth consecutive year, producing 7.7 million ounces of gold at total cash costs of $460 per ounce, positioning Barrick as one of the lowest-cost senior gold producers. (source)
George Kesarios explains here that gold prices can even move under production costs like in the 1990s, but he sees the production price around 1000 US$.
In the second part we explain which of these long-term fundamentals for gold and silver are still positive by April 2013.
In the latest update we explain that the Fed destroyed the gold price in the early 1980s, but now they will continue to be the biggest supporter of the gold price for years.
Disclaimer: The opinions expressed above are not intended to be taken as investment advice. It is to be taken as opinion only and we encourage you to complete your own due diligence when making an investment decision. Even if we often write about Forex trading, our advices aren't written for day traders who follow technical channels, but rather for mid- and long-term investors. Our aim is to show discrepancies between fundamental data and current asset valuations, which can lead in mid-term to an inversion to technical channels.