Gold’s Luster Tarnished

Gold’s Luster Tarnished explained by professional Forex trading experts the “ForexSQ” FX trading team.

Gold’s Luster Tarnished

Gold has a dual role as both a currency and a commodity. Over the course of history, gold has intoxicated people. Long before paper currencies, gold has been money — hard money. The lustrous yellow metal is rare but it is durable, divisible, consistent, convenient and it possesses value within itself. Buyers and sellers establish the value of gold. Gold tends to appreciate during times of fear, inflation and a lack of faith in paper currencies.

Gold tends to depreciate when real interest rates rise as it must compete with other assets that pay interest and dividends.

The global pricing mechanism for gold is the U.S. dollar, by virtue of the dollar’s position as the reserve currency of the world. When the dollar appreciates the price of gold tends to move lower. This is because as the dollar gets stronger versus other currencies, gold naturally gets more expensive in other currency terms. Classic economics teaches that a higher price leads to increasing production and lower demand. Conversely, a declining dollar tends to be supportive of the price of gold. Therefore, there is a strong inverse correlation between the value of the dollar and the price of gold in dollars. Gold is highly sensitive to U.S. dollar interest rates, low interest rates support the price of the yellow metal and high interest rates cause the price to lose value.

The inverse correlation between gold and the dollar holds true, not only for gold, but also for many commodities due to the dollar’s position in the global economic arena.

Beginning in 2005, gold embarked on a six-year bull run that took the price to highs of $1920.70 per ounce, based on the active month COMEX gold futures contract in September 2011.

Since then, the price has reversed course making a series of lower highs and lower lows. In July 2015, gold made yet another lower low as it broke through a key support level at $1130 per ounce. While the price of gold is significantly below the 2011 highs, there are many signals that the price is still expensive based on a number of factors.

Gold is still higher than in the past

On August 7, 2015, gold was trading at $1093 per ounce. The price, which has dropped over $800 in four years, has been weak. However, a quick look at the history of nominal gold prices tells us that gold may still be historically expensive at prices over $1000 per ounce. Consider that prior to 2008 the yellow metal never traded above $875 an ounce, which was the 1980 highs. In fact, on January 1, 2000 the gold price opened for trading at only $283 per ounce. This is a superficial analysis because the nominal price of gold tells only a small part of the story. A look at inter-commodity spreads between gold and other precious metals is a far better method of assessing the current value proposition for gold.

Divergence says gold is still expensive

Platinum and silver are both precious metals. While gold has a dual role as a currency and a commodity, both platinum and silver have far more industrial applications than gold does.

At the same time, platinum and silver have many of the same characteristics as gold and their prices tend to move together over time. Therefore, understanding the price relationships between gold and its two precious cousins is helpful in understanding value.

As of August 7, 2015, platinum was trading at a $132 discount to the price of gold. Platinum is rarer than gold and it has a higher production cost. Over the past four decades, platinum traded at a premium to the price of gold most of the time. Therefore, the discount is a divergence from historical norms.

Over the past four decades, the average of the silver-gold ratio has been 55 ounces of silver value in each ounce of gold value. As of August 7, 2015, the current prices of silver and gold stand at levels where it takes around 73 ounces of silver to purchase one ounce of gold.

This level is a divergence from the historical norm of the silver-gold ratio.

Therefore, given the divergence from historical norms, either platinum and silver were too cheap on August 7 or gold was too expensive based on relative value. Given an overall bear market in commodity prices and a stronger dollar, the logical conclusion is that gold is too expensive.

Gold at over $1000 per ounce is too expensive

On August 7, 2015, the price of platinum was around $963 per ounce. A return to long-term normal trading levels against gold would imply a price for gold of less than $1000 as platinum historically is more expensive than the yellow metal. Additionally, a return to the 55:1 long-term average against silver would imply a gold price of $811.25 given silver at $14.75 per ounce.

While the price of gold has dropped dramatically over the past four years, it remains expensive when compared to other precious metal prices. Gold broke a major support level in July 2015 and it could be heading lower in coming weeks and months.