The price of gold is moved by a combination of supply and demand, interest rates (and interest rate expectations), and investor behavior vis a vis risk. That seems simple enough, yet the way those factors work together is sometimes counterintuitive. For instance, many investors think of gold as an inflation hedge.
That has some common-sense plausibility, as paper money loses value as more is printed, while the supply of gold is relatively constant. However, the relationship between gold and inflation is weak at best. Interest rates and overall market volatility are far better predictors of gold's performance in the short run.
- Supply, demand, interest rates, and investor behavior are key drivers of gold prices.
- Gold is often, but mistakenly, used to hedge inflation under the belief that gold will appreciate and offset inflationary pressures.
- Gold is subject to investor sentiment about risk. But this relationship is tentative at best, as gold can be caught up in a risk off commodity slide and decline with other commodities.
- Gold does not yield any interest income; in fact, it costs money to hold the yellow metal, with storage and insurance being among the costs of holding gold.
- Given gold's propensity for erratic moves and a seemingly unpredictable relationship to other assets, it is recommended that gold comprise no more than 10% of any portfolio.
Correlation to Inflation
Economists Claude B. Erb, of the National Bureau of Economic Research (NBER), and Campbell Harvey, a professor at Duke University's Fuqua School of Business, have studied the price of gold in relation to several factors. It turns out that gold doesn't correlate well to inflation.
That is, when inflation rises, it doesn't mean that gold is necessarily a good bet. This is best seen through the decline of gold during 2022 while inflation was rising at around 7%. (see chart below).
Gold as a Risk On/Risk Off Asset
Depending on market circumstances, gold may garner some support during economic and market uncertainty. At the same time, gold is a commodity that only has an intrinsic value, meaning it's worth what the market says it's worth.
That exposes gold as a dead commodity, where when extreme "risk off" sentiment hits the markets, gold may decline alongside other commodities, as investors seek to cash out of commodity holdings and move to safer ground, e.g., U.S, Treasurys. So it's a thin line between gold benefiting from mild market volatility (gold up), and gold depreciating during extreme market turmoil (gold down), when gold will be sold alongside other commodities.
In their paper titled The Golden Dilemma, Erb and Harvey note that gold has positive price elasticity. That essentially means that, as more people buy gold, the price goes up, in line with demand. It also means there aren't any underlying "fundamentals" to the price of gold. If investors start flocking to gold, the price rises, no matter what shape the economy is or what monetary policy might be.
Gold prices aren't completely random or the result of herd behavior. Some forces affect the supply of gold in the wider market, and gold is a worldwide commodity market, like oil or coffee.
Unlike oil or coffee, however, gold isn't consumed. Almost all the gold ever mined is still around and more gold is being mined each day. If so, one would expect the price of gold to plummet over time, because there is more and more of it around. So why doesn't it?
Aside from the fact that the number of people who might want to buy it is constantly on the rise, jewelry and investment demand offer some clues. As Peter Hug, director of global trading at Kitco, said, "It ends up in a drawer someplace." The gold in jewelry is effectively taken off the market for years at a time.
Even though countries like India and China treat gold as a store of value, the people who buy it there don't regularly trade it (few pay for a washing machine by handing over a gold bracelet, for example). Instead, jewelry demand tends to rise and fall with the price of gold. When prices are high, the demand for jewelry falls relative to investor demand.
Interest Rates Matter
Interest rates have a significant inverse influence on the price of gold over the long term, as seen in the chart above. Note that gold prices rose significantly in response to the Fed rate cuts driven by the COVID pandemic in early 2020. As U.S. rates hit bottom, gold then leveled off and moved sideways as Fed guidance indicated rates would remain near zero for the foreseeable future.
Finally, in 2022, in response to high inflation, the Fed indicated interest rates would rise until inflation was brought under control. Note that during this period inflation remained highly elevated, but gold prices did not rise. Instead they began to fall as the Fed hiked interest rates and offered further tightening guidance, making interest-bearing securities relatively more attractive.
Hug says the big market movers of gold prices are often central banks. In times when foreign exchange reserves are large and the economy is humming along, a central bank will want to reduce the amount of gold it holds. That's because gold is a dead asset—unlike bonds or even money in a deposit account, it generates no return.
The problem for central banks is that this is precisely when the other investors out there aren't that interested in gold. Thus, a central bank is always on the wrong side of the trade, even though selling that gold is precisely what the bank is supposed to do. As a result, the price of gold falls.
Central banks have tried to manage their gold sales in a cartel-like fashion, to avoid disrupting the market too much. Something called the Washington Agreement essentially states that the banks won't sell more than 400 metric tons in a year. It's not binding, as it's not a treaty; rather, it's more of a gentleman's agreement—but one that is in the interests of central banks, because unloading too much gold on the market at once would negatively affect their portfolios.
Besides central banks, exchange-traded funds (ETFs)—such as the SPDR Gold Shares (GLD) and iShares Gold Trust (IAU), which allow investors to buy into gold without buying mining stocks—are now major gold buyers and sellers. Both ETFs trade on the exchanges like stock and measure their holdings in ounces of gold. Still, these ETFs are designed to reflect the price of gold, not move it.
Is Gold a Good Hedge Against Inflation?
Despite market lore that gold is a good hedge against inflation, the reality is much more mixed, meaning the two are essentially uncorrelated. This can be seen in the chart above, where inflation spiked in 2022, but gold retreated as interest rates rose.
Is Gold Sensitive to Interest Rates?
Because gold does not offer any return (apart from price appreciation/depreciation), it tends to respond inversely to interest rate moves. As interest rates rise, gold loses demand in favor of interest-bearing securities, such as short-term U.S. Treasurys or other government securities.
Where Does Gold Fit Into a Portfolio?
Remember, gold is a commodity and it should be viewed as such, meaning gold will frequently track broader commodity indexes, rather than deviate significantly from the overall commodity market. As a result, for portfolios, gold should form only a small portion of the overall allocation to commodities—5% to 10% maximum gold holdings is the going wisdom for a diversified portfolio.
The Bottom Line
Gold is that magical, shiny metal of which dreams are made, to paraphrase a line from the movie "The Maltese Falcon." As such, gold stands out among commodities as a seemingly separate type of commodity, and indeed there are many differentiators between gold and other commodities.
Gold can best be viewed as a currency with lower volume and a close relationship with global interest rates. But gold also stands out for being relatively uncorrelated to other key assets, sometimes benefiting from market volatility, and at other times losing ground along with other commodities during periods of extreme volatility. Above all, given gold's proclivities to act in a counterintuitive fashion, it is best kept to a small allocation in an overall portfolio, for example, 5%.