What drives gold prices?

Types of Demand

Although gold is often clumped together with other commodities (oil, copper, aluminium, wheat) and is said to have been participating in the global commodity bull, it is important to understand that what drives the price of gold is very different from what drives the prices of the other commodities. Briefly I wish to distinguish various forms of demand that can affect commodity prices in order to illustrate how vastly different the supply demand dynamics in the gold market are from other commodities. This analysis is important because the changing macro environment suggests that gold may decouple from other commodities and benefit from both inflation and deflation, while commodities at large will suffer in a deflationary environment. My analysis draws heavily from Antal Fekete, Jullian Phillips, and others.

Since all prices today are expressed in an inherently inflationary unit (paper currencies such as dollars, euro's, or yen), this makes the analysis a little harder as we must distinguish a real rise in prices from a cosmetic rise in prices on account of increased money supply. What compounds the issue further is that money is not neutral and an increased money supply actually has a real effect on commodity prices.

Like any other good or services, commodity prices are determined by supply and demand. I distinguish 3 types of demand:

1. Industrial demand is that demand for industrial use, productive enterprise, or consumption. The good is destroyed or transformed so as to make recovery hard.
2. Monetary demand is that demand as a result of a commodities status as money - it is widely transacted as a medium of exchange. If my meaning is unclear, please see my article on money. Currently, no commodity meets this criteria.
   
3. Investment demand is any demand that is not industrial demand or monetary demand. It is easier to state what isn't investment demand than what is because many different things qualify. I use it as a catch all phrase for speculation, hedging, and even outright investment.
   

My thesis is that industrial metals, energy, grains, everything you would traditionally consider commodities are driven by industrial demand and to a small extent investment demand. The global economy, especially the BRIC countries, has been powering ahead in the last few years and have been one of the major factors affecting the prices of these traditional commodities. A rapidly expanding money supply has also been responsible, but I venture that the monetary cause has been cosmetic and not real. That is, if money supply doubles, the price of copper will around double. Thus, if copper has risen 8 fold and money supply only doubled, my interpretation is that the industrial demand for copper has risen around 4 fold.

In contrast, the price of gold is determined solely by investment demand. Something like 90% of above ground gold is still in circulation. Thus, money supply growth has a real effect on the price of gold. If money supply doubles, the price of gold will more than double. This is because one purpose gold serves is as a hedge against inflation (money supply growth). It's more important investment purpose, however, is a hedge against bad times. The price of gold last spiked in 1980 and steadily declined until 2000 during probably the greatest secular bull in history. This was despite the money supply in all countries expanding quite rapidly during the same era. Since 2000, the price of gold has taken off for 2 reasons: money supply is still increasing, but more importantly, the US and western Europe have now been in secular bear markets. If economic prospects worsen, expect the price of gold to take off further.

The reader must be wondering why I distinguished monetary demand from industrial and investment demand if no commodity currently qualifies. The reason is because there is a very real dollar crisis. I suspect it will not actually pan out into a crisis because the Fed will be forced to choose deflation rather than destroy the currency, but if a crisis does ensue and the public loses faith in fiat currencies, then the world may return to a de facto gold standard. Should such a scenario come to pass, I cannot begin to describe the explosive effect it will have on the value of gold. I would not be surprised to see gold increase 5 to 10 fold in value virtually overnight.

Many other commentators will maintain that gold is money. Technically, it is not because it is not the preferred medium of exchange. However, neither has it been completely de-monetized, which is why it is driven by investment demand and not industrial demand. As someone who has been long gold for a while, I can only hope that we enter a de facto gold standard. Anyone holding bullion (and not paper claims to it!) will profit tremendously.

Macro Outlook

It is my opinion that the Fed is currently faced with the choice between deflationary Scylla or hyper-inflationary Charybdis. Should the Fed navigate the economic ship towards the gaping mouth of Charybdis, all commodities will experience nominal price increases, but only gold and other precious metals will experience additional real increases. On the contrary, should a deflationary environment ensue I suspect all commodities (with the possible exception of oil and certain key grains) will experience falling dollar prices, but gold will continue to gain in value as it remains a hedge against declining prospects. Keep in mind, however, that if the environment is sufficiently deflationary, dollars may gain value faster than gold and the price of gold will actually fall, which makes trading for such an environment hard unless one is properly hedged. A relative value play is called for.

When the global economy decouples from the US slowdown, I suspect commodities at large will continue their bull market. However, in the short term, I would not be surprised to see them take a sizable knock as the true extent of the recent excesses becomes clearer.

It seems odd that I am universally bullish on gold. Surely there no such thing as a free lunch. Indeed, if it turns out that the Fed is able to navigate the stormy waters with success then the stored potential in gold will quickly dissipate. There is also the additional concern that a sufficiently deflationary environment can have a negative real effect on the price of gold. If one is long gold, one should have carefully thought-out stops in place.

For a more detailed analysis of gold's prospects in various macro environments, see: gold - how high will it go.

Even Better Than Gold: Silver

In light of our discussion, silver is a very curious case because it is both an industrial metal as well as a precious metal. Silver has many industrial uses, but has also been a monetary metal in the past. Most notably in China where I suspect the sentiment still remains. Silver should benefit from the same factors as gold, but in addition will also be in high demand when the global economy decouples from the US and the commodity bull continues. For this reason, I would venture that silver is a better, albeit more volatile, long term investment than gold. It certainly has been since the commodity boom began earlier in the decade.