What Drives Gold and Silver?

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 “Prices are determined by one thing […] and that is people’s changing attitudes toward the emerging fundamentals”. – Martin Pring

This article is a reply to a member of our Trading Tribe that was inquiring about the drivers of Gold & Silver. Gold is the most renown commodity and a good understanding of Gold can allow you to equally understand other precious metals. In this article we shall explore the main drivers that Gold traders pay attention to:

  • In times of risk aversion, and especially when confidence in fiat currencies falters, traders shift capital away from risky assets and search for security in Gold;
  • USD trends affect Gold, since the metal is priced in USD/ounce;
  • Inflation/deflation.

What about Central Banks?

In reality, there is a fourth driver of Gold prices: Central Bank buying and selling of Gold. Gold is held by reserve managers for diversification purposes, since the value of the Gold and foreign currency reserves together is more stable than the value of Gold reserves and the foreign currency reserves separately.

Gold can also be used to fund emergency liquidity assistance or foreign exchange interventions, among other things. Finally, Central Banks take note of general economic conditions when deciding to buy or sell Gold.

Gold prices vs. Industrial Production

Gold Prices vs. 10yr-2yr Spread

There is a weak correlation between Gold prices and economic cycles – and for trading purposes it can largely be ignored. Longer-term, it does carry more weight.

In 2018 for example, Central bank and consumer demand for Gold balanced out the speculative outflows from ETFs. Below is a chart of Central Bank activity in Gold since 2010.

The Gold holdings at Central Banks are highly concentrated in the advanced economies of Western Europe and North America, a legacy of the days of the gold standard. In recognition of this, major European Central Banks signed the Central Bank Gold Agreement (CBGA) in 1999, limiting the amount of gold that signatories can collectively sell in any one year. There have since been three further agreements, in 2004, 2009 and 2014.

The PBOC is also quickly becoming a key Central Bank player in the Gold market.

However, don’t be surprized to see Central Bank Gold transactions going in the opposite direction of price. The CBGA is meant to stabilize Gold prices: European CB’s tend to be buyers during declines and sellers during upticks. And CB’s generally want to remain under the radar with their transactions.

Inflation

Lower unemployment or stronger economic activity can potentially trigger price increases due to domestic demand (which is a positive influence). Some other triggers of inflation are negative because they come from external influences like increases in commodity prices or currency differentials. Investors tend to seek “tangible goods” as a hedge against inflation, hence the correlation between Gold and CPI.

But there is also a psychological component: financial assets, as well as fiat currency are “intangible” assets. They are all “pieces of paper” at the end of the day. So, when the future outlook gets gloomy, investors tend to search for safety in “hard assets”. And that is why hard assets, such as oil, natural gas, silver, farmland, diamonds and real estate all tend to be inversely correlated with stocks and bonds.

However, of the 3 main influences, inflation has the smallest effect on Gold.

The US Dollar

One of the major day-to-day drivers of Gold prices is the US Dollar. The reason is simple: Gold is priced in USD! Gold prices tend to increase when the USD gets sold. That is because in relative terms, Gold becomes more expensive. Vice-versa, Gold prices tend to decrease when the USD gets bought. That is because in relative terms, Gold becomes cheaper.

Risk Aversion

The other major day-to-day driver of Gold prices is risk aversion: when the return OF capital takes precedence over the return ON Capital. It should be evident how, in times of sharp stock market declines, investors seek the safety of Gold. And this dynamic occurs on the short time frames as well as the larger time frames.

The Hidden Driver: Confidence in Central Banks and Government

The last driver, which isn’t visible on a day-to-day basis but is always lingering in the minds of fund managers: how much credibility Central Banks and Governments have. To understand this principle, just observe the chart below.

What about Silver?

Silver has a huge array of industrial uses: it is used for electrical components in computers and household appliances such as washing machines. It also has less conventional uses, such as in photograph development, and in odour control in shoes and clothes. It is also more commonly being used in trace amounts in bandages, and is still used in X-rays.

But for day-to-day trading, one chart says it all:

Silver mimicks Gold’s movements, just with different volatility characteristics. The blue line is the Gold/Silver ratio and as it is currently, Gold is pushing the upper boundaries against Silver, which would mean that a Short Gold/Long Silver spread might actually make sense over the medium term.

Over to You

Gold and Silver can be used to diversify away from traditional FX trading. Precious metals have always been important through history, as a means of protection in times of peril and when confidence in the government authorities was in question. These dynamics have not changed.

Hopefully this article will allow you to have more confidence when approaching a Gold chart, being able to take on board the fundamentals as well as the chart-based information.

About the Author

Justin is a Forex trader and Coach. He is co-owner of www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.

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