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The Trader’s Guide to Gold Analysis

In this article, we will look at how traders can best attempt to understand the drivers of the Gold price and how it can be analysed and traded 

As a financial instrument, Gold provides traders with a store of value, an alternative investment to FX, Equities and Bonds, as well as a play on the return of inflation. It was also the basis of our monetary systems and the medium of exchange for trade and commerce between nations. Little else can move people like Gold. It has the power to take us halfway around the world in its pursuit, and there are few more passionate groups in finance than so-called "Gold bugs”. It was also the basis of our monetary systems and the medium of exchange for trade and commerce between nations. Little else can move people like Gold. It has the power to take us halfway around the world in its pursuit, and there are few more passionate groups in finance than so-called "Gold bugs”.

The Case for Gold

The chart below (source: World Gold Council) plots the long-term returns of Gold against a variety of other financial assets.These include Equities, Bonds and Commodities. What's interesting is how well the returns in Gold stand up in comparison. In fact, Gold is in the top two or three performers in each period under observation. The fact that Gold is second only to US Equities over a 10-year time frame is very notable, given that US stocks are in the midst of a much discussed, nine-year-long bull market.

Long-term returns of Gold against other financial assets

Gold has also significantly outperformed other Commodities over a ten year period, making gains of +7.7% in that time frame. This is compared to a fall of -3.7% for the wider Commodities group according to the WGC data. That outperformance confirms that Gold is different from most other Commodities regarding its association with and dual life as money and because of its limited number of industrial uses. 

Drivers of the Gold Price

Asian jewellery demand

One of the largest sources of demand for Gold comes in the form of demand for jewellery, wedding and dowry gifts from Asia. For instance, in both India and China custom dictates a gift of Gold for many major life events. Between them, China and India imported some 1900 tons of Gold in 2016. It's true to say that level of this demand has been trending lower as economic growth rates in both countries have moderated. But it remains a significant and often seasonal factor in determining the Gold price.

Inflation

Gold has historically been seen as a hedge against inflation. That is a hedge against the erosion of the spending power of paper or Fiat currencies, as they are known. Purchasing power is effectively the value of money over time, and continuous price rises degrade that value which is expressed as PPP or Purchasing Power Parity. The rate of inflation degrades PPP by the net difference between Inflation and growth in the economy. So to put in this into simple terms: If an economy has persistent inflation running at just one percent per annum and at the same time registers no real economic growth, then the value of the PPP of that currency will have degraded by almost 6% in just ten years. That degradation increases in line with any increase in the difference between inflation and growth. Gold has long been seen as the ideal hedge against such inflationary pressures. Its scarcity value (i.e. it cannot be printed as can paper money) and it's acceptance as a global medium of exchange give it an almost unique status. In fact, the cost of an ounce of gold in a given currency or currencies was, for a long time, the principal way to establish an exchange rate between those same currencies. In recent times this relationship between the Gold price and inflation has faded, simply because inflation has itself become a scarce commodity in many developed economies.

Relationship to the US Dollar

Like other commodities, gold has also been subject to the same inverse relationship to the value of the US Dollar. That is, a stronger US Dollar has typically been negative for commodity prices. It becomes dearer to foreign currency buyers of those same commodities, which are largely priced in Dollars. Gold, of course, is no different. The relationship between commodity prices and the US Dollar has itself weakened in recent times as the influence of rapidly developing economies such as China has created new sources of demand that help to offset US Dollar dominance of the commodity markets. The move away from Dollar pricing is an emerging, but growing trend and indeed Pepperstone offer their clients Gold and Silver contracts that are priced in Euros.

Risk off, Risk on

Gold has traditionally had an inverse relationship to risk among investors. That is, as risk appetite among investors rose, the price of Gold would fall. Traders swapped their positions in the precious metal, for riskier assets, such as equities and emerging market currencies. Conversely, as investors risk appetite waned and became more concerned about the possibility of loss, they sold their riskier assets in favour of holding in safe havens such as Gold and US Treasury Bonds. 

Risk-off behaviour in the Gold price versus US Government 5-year bond yields

I have plotted an example of this risk-off behaviour in the Gold price versus US Government 5-year bond yields chart above. It’s true that it's a long-term chart and it's an extreme example, but the relationship is clear for all to see. As risk appetite falls, demand for less risky assets increases. The yield or return on Government Bonds falls as their prices rise on excess demand. The price of Gold rises at the same time as haven buyers appear.

We can see a similar relationship at work here between the Gold price and USDJPY or Dollar-Yen. The Yen is a reserve currency of course, it is extremely liquid and is backed by a highly credible central bank. As such it has long been regarded as a safe haven currency,  despite Japan's decades of economic turmoil.
Gold price versus USDJPY

Gold Price Analysis

The Gold and Silver Ratio

One of the ways traders analyse the Gold price is through a comparison to its peers within the precious metals group.The medium of choice for this comparison has been Silver. The convention is to divide the price of Gold, usually quoted in US Dollars, by the Silver price quoted in the same currency.

That simple sum gives us the Gold Silver ratio or if you prefer the number of ounces of silver required to buy an ounce of Gold. Since the Autumn of 2007, that ratio has been as low as 39.6 and as high as 83.22. At the time of writing, the ratio stands at 75.4. I note however that in 1971 the figure touched as low as 18.73 and in 1995, it spiked up to 102.30.

This is a dynamic relationship as the price of both Silver and Gold are subject to change. However the fact that there is a fairly consistent positive correlation, of approximately +0.75% between the two metals means that the ratio is a valid metric.
 
Bearing in mind that strong positive correlation. One way to use this ratio would be as an indicator, but not to determine whether Gold was overbought or oversold relative to Silver. 
Rather, it should be used as an indicator of Bullish or Bearish sentiment around the precious metals complex as a whole. Gold has historically been the leader in this group and therefore a spike in the Gold Silver ratio could be interpreted as a bullish signal for the Gold price and potentially the wider PM group. 
Gold Silver ratio - weekly price of Gold over five years

In the chart above I have drawn the weekly price of Gold over five years and applied the Gold Silver ratio in the bottom window. I have highlighted several instances where a relative peak in the Gold Silver ratio preceded further gains in the Gold price. I have also plotted the RSI 14 in the middle window to provide a comparison. Of course, as with any indicator, there will be false signals or misinterpretations. 

Note that there are similar ratios between Gold and Platinum, Gold and Palladium as well as those between each of these precious metals and Silver. 

I hope this article has given you a taste of the Gold story its interconnections with the world economy and some of the drivers for changes in its price; You can find full details of the precious metal contracts we offer here contract details
 

For more of Pepperstone market analyst Darren Sinden's content, you can check out his Daily Market Update (key market news in minutes) or follow him on Twitter.