In 2002, gold traded for less than $300 per troy ounce. In 2010, the rate popped above $1,400.
Why did gold’s value rocket up so high? How much higher do some analysts predict gold prices will soar?
Experts have four main theories to try to explain the rise in gold prices. While no theory is 100% perfect, each one has played a role in the recent cost of gold.
Theories for Increases in the Price of Gold
1. Commodities and Inflation
Perhaps the simplest theory is that all commodities, including gold, rise with inflation just as everyday consumer goods do. You can see the relentless effects of inflation when using the Consumer Price Index (CPI) for the U.S. The CPI tracks the costs of goods and services in over 200 item categories to provide a realistic cross-section of how far our dollar goes. The items it tracks includes such items as food, housing, clothing, vehicles, medical care, education, and haircuts. Using CPI tables, if you spent $100 acquiring a variety of goods and services in 1914, these same items and services would cost you $2,213.09 in February 2011. This aptly describes how commodities rise in value over time.
How much of the recent rise in gold’s price can be attributed to the relationship between gold prices and historical inflation levels? Using a Consumer Price Index calculator, $300 in 2002 would be worth $363.63 in 2010, reflecting 21.2% total inflation. In that same time frame, gold soared 367% to over $1,400. It’s clear that inflation has only played a small role in the increase of gold’s price.
The government’s recent extreme quantitative easing will continue to push gold’s prices higher given the inevitable reduction in the value of the dollar. But other factors and theories will factor in as well.
2. Rising Demand for Gold
Is the rise in gold’s value tied to a simple rise in demand, including jewelers’ desire to acquire gold? While demand does play a vital part in pricing of any product or commodity, take a look at the chart below and notice how high the total demand of gold was in 2001, when prices were still well below $300 per ounce. The average yearly demand for gold from 1994 to 2000 was just under 3,000 tons.[table “8” not found /]
The average annual demand from 2001 to 2010 is 3,569. Demand is up about 20%, but that’s not enough to be the only influence.
3. Gold as “Safe Haven” Currency
Gold is a globally recognized form of currency, and it used to act as the world’s reserve currency before being replaced by the dollar. You’d be hard-pressed to find a country that will not accept gold, so you can imagine what happens when runaway inflation, political unrest, and natural disaster erodes the value of any national currency. When the future value or usage of paper currency is in doubt, people turn to what they view as the stable monetary form that they can use anywhere in the world: gold. Amid uncertainty, it’s the safest haven of all.
Generally, when the value of the dollar drops, the price of gold rises. This inverse relationship results in large part because gold is priced in dollars, so a lower-valued dollar means you need to spend more for the same amount of gold. From 2002 to the end of 2010, the US dollar lost over 33% of its value against the Euro. Gold made an inverse, more exaggerated move during this time, jumping from $278 to $1,420.
4. Investors Wield Power Over Gold
- In 2002, the investment demand for gold in the form of gold bars, coins, and gold-backed investment products like exchange-traded funds (ETFs) made up only 10% of the total gold demand. On the other hand, jewelry made up over 79% of overall demand in 2002.
- In 2010, gold investors made up 35% of all gold demand, while jewelry constituted only 54%.
These statistics illustrate that investors were a key factor in the roughly 20% increase in overall gold demand over the past decade.
Another way of analyzing this trend is by examining futures contracts, which are sold in increments of 100 troy ounces. They’re a popular way for investors to expose themselves to gold. In early January 2002, there were only 113,020 total open positions, but by the middle of July 2010, there where almost 560,000 total open positions for gold futures contracts. Given that futures contracts directly affect gold prices due to the fact that the futures market brings together a high volume of buyers and sellers of gold, it is easy to recognize the significant influence of investors on gold prices.
To add to this argument, there were only 22% more long futures contracts than there were short in January 2002, meaning that the number of gold bulls and bears were fairly equal. But in July 2010, there were 359% more bullish gold contracts than bearish contracts. Thus, the massive surge in gold futures being traded, combined with the increase in gold bulls relative to gold bears, has no doubt had a profound effect on the rise in gold prices.
Now, experts are asking where we should expect gold prices to go. Will they soar even higher, or are they coming down? To figure things out, investors will have to carefully consider five important – and difficult – questions:
- Will the surge of gold buying by India, China, and other governments further increase prices?
- Will the strength or weakness of the U.S. dollar continue to inversely influence gold prices as it has historically?
- Will the gold futures market continue to experience significant growth, subsequently further impacting the price of gold?
- Will gold eventually retake its place as the world’s reserve currency?
- As some have predicted, could prices reach over $5,000 per ounce?
While inflation, demand, and gold’s safe haven status have played an important role in gold prices, it was the speculators’ rise to power that has an increasing amount of influence on gold prices since 2002. As economic and political woes weighed heavily, traders and hedgers from all over the world were able to drive prices up to incredible highs. And, of course, the rise of online futures trading and new gold-based ETFs have given investors an even larger scepter to wield.
While it is nearly impossible to answer these questions with certainty, understanding the various influences on gold prices will help you make smart, informed predictions for the future of gold prices. What other factors are you considering when you think about the future volatility of gold or other commodities?
(photo credit: Shutterstock)