It is important to distinguish the forces and players that drive gold prices in the short term — measured in days, weeks and sometimes months — from those that determine the long-run trend and average price over many years.
In the short term, the key players tend to be institutional traders and speculators — the trading desks at banks, hedge funds and other financial firms — who operate principally in “leveraged” futures and derivative markets.
With little cash down, these are the folks who are most responsible for gold’s sometimes extreme price volatility, often with big ups and downs. Rather than allowing long-term forces to push gold prices up at a more measured rate, these traders were responsible for driving the gold price sharply higher last summer to its all-time high near $1,924 on Sept. 6, and then driving it back down to about $1,525.
What motivates these traders is the necessity to make short-term trading profits. They have no lasting long-term interest or allegiance to gold as an inflation hedge, portfolio diversifier or insurance policy against economic risk.
While their collective trading volume and the size of their individual trades may, at times, be huge enough to move the price by more than a few dollars, they rarely operate in the physical market where bullion bars are actually bought and sold. And, it is in the physical market where the long-run average price over many years is determined. Here, the key players are:
➤ Retail and institutional investors that hold gold for protection against currency depreciation and debasement, domestic price inflation, and an assortment of political, economic and financial risks.
➤ Central banks that hold gold as an official reserve asset whose value, unlike foreign currency reserves, is independent of sovereign issuer risk.
➤ Jewelry consumers, who buy for some emotional “feel good” needs and desires, or as a convenient and traditional form of gold investment (in countries like India and China).
➤ And mining companies who regularly add new supply to the market — but with total quantities changing little from year to year.
It is simply the supply and demand for physical metal by these market participants that will determine the price of gold in the years ahead.
Here are the top three fundamental trends that, in my view, promise persistently tight supply and demand conditions in the physical market — and persistently rising prices for years to come:
➤ Most significantly, further monetary easing by the world’s top three central banks — the Federal Reserve, the European Central Bank and the People’s Bank of China — is likely as the great global recession continues to worsen.
➤ Irrespective of short-term cyclical weakness in both China and India, I expect long-term demand from investors and jewelry buyers in these two countries will continue, not just in the next year or two, but for many years to come — reflecting the rising incomes and growing middle classes in these two countries.
➤ Central bank interest will not only continue but will likely expand for several years — with China and Russia leading the pack. Moreover, I expect a growing number of countries underweighted in gold and overweighted in dollars and euros joining in this official-sector gold rush.
Jeffrey Nichols is a recognized expert on the economics of precious metals markets. He is managing director of American Precious Metals Advisors (www.NicholsOnGold.com) and also serves as senior economic advisor to Rosland Capital LLC (www.RoslandCapital.com), a retail dealer of precious metals investments and numismatic coins. Follow Jeff Nichols on Twitter @ NicholsOnGold.