For us, gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV) 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". 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. Some gold bulls base their analysis mostly on the explosion of public debt, while the opponents argue that gold brings no income, but has only a cost of carry.
In this post we try to enumerate most fundamental factors.
For us, gold and silver prices are driven by six major fundamental drivers:
- Price movements of other commodities in combination with global demand for these commodities, an "indirect pricing".
- Global and in particular US inflation
- Trade imbalances and the U.S. debt and twin deficits
- Central bank's activities like money printing or gold purchases and sales
- Real interest rates and in particular the ones in the US
- 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, a proxy for Chinese investments, are closely linked.
Gold, copper, zinc prices compared (source)
Higher supply of U.S. oil and slower global growth helped to weaken Brent and consequently gold prices. Copper was under pressure by slower Chinese growth and the regulation of Chinese housing purchases.
2) Gold and silver prices are correlated to global inflation
Metals appreciated until 2011 with rising inflation in emerging markets, e.g. here Chinese CPI and PPI.
Chinese inflation (source)
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 the summer of 2011, but also between the spring 2008 and autumn 2008, global inflation figures fell, and consequently also gold and silver prices.
Gold versus US inflation rate (source)
Many statistics concentrate on US inflation to describe the relationship with gold prices: in a world where soon half of global GDP will be achieved in emerging markets, this is not accurate anymore. During the end 1970s "gold bubble", however, U.S. inflation was the main driver of high gold prices (see more under point 5).
With falling commodity prices, global inflation has diminished. Still, there is upwards pressure on wages in emerging markets and some economies like in Germany, while most other developed nations have very low wage increases.
3) Gold and silver prices appreciate with trade and growth "im-balances" against the United States
Gold and silver typically rise together with economic improvements in emerging markets and/or Europe when the U.S. cannot cope with this pace. The best example was between 2009 and summer 2011, when 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 invested in the local economy: Investments in real estate or fixed assets boost commodity prices and via point (1) the gold price.
- or they must exported with the financial account of the balance of payments
If capital exports are smaller than the current account surpluses, then the currency is a rare good, it typically appreciates. Due to the stronger real effective value of the yuan, the Chinese current account surplus has considerably weakened. Recent data even showed a Chinese trade deficit, even if distorted by the Chinese new year.
China Current Account and Real Exchange Rate (source Paul Krugman)
Stronger investments and real estate prices in the U.S., however, tend to weaken the gold price. They rather raise expectations of a US interest rate hikes (see point 5).
The combination of less Chinese investments, capital exports from China to the U.S., higher U.S. house prices have recently depressed gold and silver valuations.
4) Gold prices are correlated to central banks' activities
For decades central banks in emerging markets relied on buying US treasuries. Due to higher wage increases, higher inflation and the interest rate parity, the emerging market currency depreciated with time.
This fulfilled a double advantage: the central bank had inflation-resistant reserves and could profit on an appreciation of the dollar. From the year 2002 on, however, most currencies improved against the dollar and destroyed a part of central banks' profitability.
In the Bretton Woods system, 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 gold share of central banks of for emerging markets is still 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) could build up their reserves during the Bretton Woods era.
The IMF demonetization of gold policy urged central banks to sell their gold, countries like the UK and Switzerland followed these calls. Together with falling inflation (facto r2) and a strong US current account (factor 3) these gold sales helped to put downwards pressure on the gold price between 1998 and 2005, while the strong rise of other commodity prices (factor 1) sustained it.
Today the Fed is still the leading central bank in an implicit N:1 system of central banks. A weak US economy urges the Fed to act within its double mandate of low inflation and reduction of unemployment. The Fed often implements easing measures and expands its balance sheet. Typically the 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.
In 2011 and 2012 more and more central banks in emerging markets 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 recent discussion about the Cyprus gold reserves had woken up fears about the gold sales of other central banks like Spain and Italy. The Fed might exit its latest easing operations.
5) Gold and silver prices rise with falling real interest rates
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 2006.
- by item (2), when inflation rose more quickly than rates - between 1977 and 1980.
Volcker ended the latter period when he hiked interest rates that high so that inflation got beaten. At the same time he killed the gold price.
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 diminish.
The potential early exit from QE3 and the Fed's opinion that U.S. rates might go up to 4% over the longer run and in 2015 to 1% has surely had a negative influence on gold prices, but interestingly not much on U.S. treasury yields.
FOMC Minutes March 2013: Expected Fed Funds Rate
Long-term US treasury yields are still near record low levels. This implies that the market does not believe in the FOMC estimate, but gold and silver are already victims.
6) Gold and silver prices rise with private physical supply and demand
Economic improvements especially in China and India, create higher physical demand of gold and silver. The Indian savings rate is over 20%, a big part of savings move into gold. To a lower extent than other commodities, gold and silver prices depend on the supply and demand situation. Silver has, opposed to gold, more industrial use. Therefore demand in emerging markets is more important for silver. Silver reacts more strongly to physical supply and demand than gold.
Historically physical demand had an influence. 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 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.
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, do not affect the price very strongly.
In the second part we indicate which of these six fundamentals factors are still positive and which are not.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.