The great technical analyst Martin Pring once said:
“The more I work with markets, the more it becomes apparent that prices are determined by one thing and one thing only, and that is people’s changing attitudes toward the emerging fundamentals”.
In this article, we will dig into what market participants care about when dealing with the fundamentals of gold.
What every trader ought to know about gold
Gold is the king of precious metals and tends to have an impact on other precious metals like silver and platinum, helping to dictate their price.
There are three big reasons that gold is the most important precious metal in the world:
- Central Banks hold enormous amounts of gold as part of their official reserves.
- In times of risk aversion, traders and investors stop thinking about “return ON capital” and concentrate on “return OF capital”. This shifts investors away from risky assets to the security that gold has typically offered.
- Perhaps the most important economic indicator, Inflation, can affect the demand for gold as it is seen as a hedge against inflation’s erosion of a currency’s buying power.
Central Banks
Central Banks own a lot of gold. One reason for this is due to gold’s historical association with banknotes and coins. In the past, a coin or banknote could be redeemed for an equivalent value of gold.
These days, central banks hold gold for diversification purposes. The value of gold and foreign currency reserves put together is more stable than the value of either when held separately.
Collectively, at the end of 2021, central banks held around 35,500 metric tonnes of gold: approximately 20% of all the gold ever mined. They buy and sell large amounts of the metal based on their future expectations for the economy. Central Banks may have the power to influence the price of gold more than any other factor out there.
Risk tolerance
The “risk-on, risk-off” dynamic tends to hold importance for intraday and intra-week trading of the precious metal.
In times of sharp stock market declines, which can induce risk-off sentiment in investors, traders can flee to the safety of gold, increasing demand and pushing up its per-ounce price. On the other hand, during times of risk-on sentiment in the market, the opposite can occur. These shifts in market sentiment can occur over time or very quickly. So, intraday traders should also be aware of this dynamic.
Inflation dynamics
Inflation describes the general increase in the price of goods and services. It’s why you could buy more with $100 USD in the 1990s than you could today.
Inflation erodes the value of savings over time and decreases the burden of debt to the borrower over time.
The triggers for inflation typically include:
- Low unemployment
- Stronger economic activity
- Central Bank spending
- Government spending
- Increases in commodity prices
- Increases in workers’ wages
Investors actively seek “tangible goods” as a hedge against inflation. There is also a psychological component to this behaviour: currencies, stocks, bonds and ETFs are all “intangible” investment vehicles. They are all “pieces of paper” at the end of the day. So, when the outlook gets gloomy, such as periods of very high inflation, investors tend to search for safety in “hard assets”.
Wait A Moment…
After having seen these three price drivers behind trends in gold, one might ask: “Why does it seem that gold follows each of the three dynamics sometimes, whilst other times it does not?”
The answer is that like currencies, gold does not trade on a single driver all the time. Depending on the state of the markets, each driver can come into play. Then, another one takes its place equally as fast.
