Worldwide, gold is seen as a valuable commodity with intrinsic value. Until 1934, the U.S. dollar was backed by gold, with notes redeemable in exchange for the precious metal. Today gold remains valuable for its rarity and ability to create jewelry and other beautiful objects. It's also an investment vehicle in the commodities market. Like any commodity, gold has its ticker symbols, contract value and margin requirements. The investment is valued by supply and demand — mainly speculative demand.
However, unlike other commodities, the value of gold is less affected by consumption and largely influenced by the status of the economy. It's generally accepted that its price is tied to movements in U.S. interest rates. Over the course of history, gold's value has displayed tendencies counter-cyclical to the strength of the economy.
Influences on Gold Prices
In the world economy, gold remains one of the most complicated assets to price. Unlike stocks, currencies and other commodities, its value isn't determined by fundaments or physical supply and demand.
However, in many cases the value of gold moves indirectly with the strength of the economy. When the economy is doing well and growing, gold prices tend to fall and vice versa when the economy contracts. That said, many macroeconomic variables exhibited in growing and contracting economies play a greater role in influencing the price of gold. These factors include interest rates, oil prices, inflation and the foreign exchange market.
As a commodity, gold is typically viewed as an alternative investment. Alternative investments typically help investors hedge against market volatility. Interest rates are the primary factor in determining their attractiveness. When economies experience recessions, the central bank will manipulate interest rates to stimulate growth. As recently as the 2008 financial crisis, central banks around the world implemented quantitative easing, effectively lowering interest rates to near zero. At the same time, gold prices rose to highs of $1,900 per ounce. As interest rates fall, alternative investments such as gold become more attractive. The relationship between gold and interest rates often exhibit a negative correlation.
As an investment, gold is held to hedge against inflation. By definition, when inflation is high, the value of paper money falls in terms of the goods and services sold in the marketplace. In cases such as these, investors flock to investments that don't lose value. Fundamentally, gold is a precious and rare resource that holds high value. As a result, it usually has a direct relationship with inflation, with demand for gold increasing during inflation and decreasing during deflation. In the years leading to the financial crisis, inflation in the United States hovered around 3 percent. To put this in perspective, advanced economies target 2 percent inflation benchmarks annually. As a result of inflation, gold prices reached peaks during economic crises.
In the commodities market, assets are typically quoted in U.S. dollars. As a result, changes in the foreign exchange market can influence changes in gold. When the U.S. dollar is weak, gold becomes cheaper for other nations to purchase. As a result, the demand for gold increases as investors seek an investment that maintains value. After the 2008 recession, the U.S. dollar exhibited signs of weakness and rising gold prices. By contrast, the strong dollar of the late 1990s was tied to relatively low gold prices. Needless to say, this relationship does not always hold, as we saw earlier in 2015.
Along with gold, crude oil is a commonly traded asset in the commodities market. The price of oil is determined by supply and demand and futures contracts. Theoretically, cheaper oil means lower inflation; as a result, gold is negatively affected since it's considered a hedge against inflation. Besides lower inflation, cheaper oil is a crucial indicator of economic growth. Decreasing oil prices increase spending and consumption in the economy. Likewise, better economic prospects positively affect equities and negatively affect non-income-generating assets such as gold. (See also What Determines Oil Prices?)
Given its relationship with numerous economic indicators, gold is widely considered counter cyclical to economic growth. By definition, assets that negatively correlate to the overall state of the economy are said to be counter cyclical. Throughout history, gold has reacted positively when interest rates are low, inflation and unemployment high, and currencies weak. These macroeconomic indicators point to slowing and contracting economies. In this scenario, gold is considered a haven because it retains or increases value during market turbulence. Gold is often sought after by investors through economic woes in order to limit their exposure to losses.
Essentially, it's an asset that can't be manipulated by interest rate policies and is often used as a hedge against inflation. While those variables may have a stronger influence on gold prices, an expanding trade deficit is said to positively affect the long-term outlook for gold prices and exchange-traded funds. That said, as interest rates rise and the economy shows signs of growth, gold will lose favor for equities and income-generating assets.
The Bottom Line
Although the gold standard is no longer the monetary system used throughout the world, it's still considered highly valuable. Besides of its use in jewelry, gold is an extremely desirable investment vehicle. Gold investments can come in the form of stocks, exchange-traded funds or future contracts. Typically, gold reacts positively during market turbulence and negatively during economic growth. Since it maintains its intrinsic value, gold is often referred to as a haven. When fears about the security of other investments such as equities and bonds rise, many flock to gold because of its highly liquid nature. However, since the U.S. economy has continued to show signs of growth and the Federal Reserve is speculating forthcoming monetary changes, the value of gold will surely fluctuate. (For more, see The Effect of Fed Fund Rate Hikes on Gold.)