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Gold Fundamentals

The factors that matter

Gold is usually the first thing that comes to mind when we speak about commodities. Gold is also the first thing that comes to mind when the going gets tough and investors seek refuge. Gold is also a hedge against inflation and a fierce enemy of the USD. Thus we will need to speak about both of them in order to grasp the fundamentals of Gold.

1. Gold

Gold... oh Gold! The King of all commodities!

A "London Good Delivery Bar", the standard unit of traded gold, is made from 400 troy ounces of gold.

Source: World Gold Council.org

It is a fact that the relationship between Gold and the USD is a reflection of the battle between tangible assets (like Gold, Silver, Crude Oil, Aluminum, etc.) and financial assets (ETFs, Bonds, etc.). Traditionally, the USD has been the representative currency in any analysis of Gold mainly due to the fact that it's the preferred means of exchange worldwide. There is a long lasting connection between Gold and paper currencies, which culminated with the Bretton Woods agreement. Yes: Gold has had a role in establishing the current currency order. So Gold is not just shiny; it has also played a fundamental role in the economy. But let's proceed with order.

1885 - While digging up stones to build a house, Australian miner George Harrison found gold ore near Johannesburg in 1885, beginning the South African gold rush.

Source: World Gold Council.org

2. Some History

Gold has always played an important role in the international monetary system. Gold coins were first struck on the order of King Croesus of Lydia (an area that is now part of Turkey), around 550 BC. They circulated as currency in many countries before the introduction of paper money. Once paper money was introduced, currencies still maintained an explicit link to gold (the paper being exchangeable for gold on demand).

In 1871, the newly unified Germany, benefiting from reparations paid by France following the Franco-Prussian war of 1870, moved away from silver in favor of Gold. Hence, Germany backed the Deutsche Mark with a gold standard, and most nations then started to follow suit, due also to the then economic and political dominance of the UK and the attraction of accessing London's financial markets. However, this transition to a pure Gold Standard, in some opinions, was more based on changes in the relative supply of silver and gold. Regardless, by 1900 all countries apart from China, and some Central American countries, were on a Gold Standard. This lasted until it was disrupted by the First World War. Periodic attempts to return to a pure classical Gold Standard were made during the inter-war period, but none survived past the 1930s Great Depression.

Central banks had two overriding monetary policy functions under the classical Gold Standard:

a) Maintaining convertibility of fiat currency into gold at the fixed price and defending the exchange rate.

b) Speeding up the adjustment process to a balance of payments imbalance, although this was often violated.

2.1 The Gold Standard

(Quoted from worldgoldcouncil.org)

Under the Gold Standard, a country's money supply was linked to gold. The necessity of being able to convert fiat money into gold on demand strictly limited the amount of fiat money in circulation to a multiple of the central banks' gold reserves. Most countries had legal minimum ratios of gold to notes/currency issued or other similar limits. International balance of payments differences were settled in gold. Countries with a balance of payments surplus would receive gold inflows, while countries in deficit would experience an outflow of gold.

In theory, international settlement in gold meant that the international monetary system based on the Gold Standard was self-correcting. Namely, a country running a balance of payments deficit would experience an outflow of gold, a reduction in money supply, a decline in the domestic price level, a rise in competitiveness and, therefore, a correction in the balance of payments deficit. The reverse would be true for countries with a balance of payments surplus. This was the so called 'price-specie flow mechanism' set out by 18th century philosopher and economist David Hume.

This was the underlying principle of how the Gold Standard operated, although in practice it was more complex. The adjustment process could be accelerated by central bank operations. The main tool was the discount rate (the rate at which the central bank would lend money to commercial banks or financial institutions) which would in turn influence market interest rates. A rise in interest rates would speed up the adjustment process through two channels. First, it would make borrowing more expensive, reducing investment spending and domestic demand, which in turn would put downward pressure on domestic prices, enhancing competitiveness and stimulating exports. Second, higher interest rates would attract money from abroad, improving the capital account of the balance of payments. A fall in interest rates would have the opposite effect. The central bank could also directly affect the amount of money in circulation by buying or selling domestic assets though this required deep financial markets and so was only done to a significant extent in the UK and, latterly, in Germany.

The use of such methods meant that any correction of an economic imbalance would be accelerated and normally it would not be necessary to wait for the point at which substantial quantities of gold needed to be transported from one country to another.

2.1.1 The 'rules of the game'

The 'rules of the game' is a phrase attributed to Keynes (who in fact first used it in the 1920s). While the 'rules' were not explicitly set out, governments and central banks were implicitly expected to behave in a certain manner during the period of the classical Gold Standard. In addition to setting and maintaining a fixed gold price, freely exchanging gold with other domestic money and permitting free gold imports and exports, central banks were also expected to take steps to facilitate and accelerate the operation of the standard, as described above. It was accepted that the Gold Standard could be temporarily suspended in times of crisis, such as war, but it also was expected that it would be restored again at the same parity as soon as possible afterwards.

In practice, a number of researchers have subsequently shown that central banks did not always follow the 'rules of the game' and that gold flows were sometimes 'sterilized' by offsetting their impact on domestic money supply by buying or selling domestic assets. Central banks could also affect gold flows by influencing the 'gold points'. The gold points were the difference between the price at which gold could be purchased from a local mint or central bank and the cost of exporting it. They largely reflected the costs of financing, insuring and transporting the gold overseas. If the cost of exporting gold was lower than the exchange rate (i.e. the price that gold could be sold abroad) then it was profitable to export gold and vice versa.

A central bank could manipulate the gold points, using so-called 'gold devices' in order to increase or decrease the profitability of exporting gold and therefore the flow of gold. For example, a bank wishing to slow an outflow of gold could raise the cost of financing for gold exporters, increase the price at which it sold gold, refuse to sell gold completely or change the location where the gold could be picked up in order to increase transportation costs.

Nevertheless, provided such violations of the 'rules' were limited, provided deviations from the official parity were minor and, above all, provided any suspension was for a clear purpose and strictly temporary, the credibility of the system was not put in doubt. Bordo2 argues that the Gold Standard was above all a 'commitment' system which effectively ensured that policy makers were kept honest and maintained a commitment to price stability.

One further factor which helped the maintenance of the standard was a degree of cooperation between central banks. For example, the Bank of England (during the Barings crisis of 1890 and again in 1906-7), the US Treasury (1893), and the German Reichsbank (1898) all received assistance from other central banks.

2.2 Why did the Gold Standard break down?

The Gold Standard broke down at the outset of the First World War, as countries resorted to inflationary policies to finance the war and, later, reconstruction efforts. In practice, only the US remained on the standard during the war. The reputation of the Gold Standard meant that there was a widespread desire to return to gold afterwards. However, differing inflationary experiences during and after the war - including the German hyperinflation of 1922-24 - meant that a return to pre-war parities was not automatically feasible. A further problem was concern, in the absence of major new gold discoveries after the 1890s, over whether there would be sufficient gold to underpin the standard. These concerns had started to surface in the first decade of the 20th century. The solution was to allow the emergence of a 'gold exchange standard' whereby central banks both acquired a higher proportion of the gold stock4, reducing the amount of gold coins in domestic circulation, and also started to hold increasing amounts of their reserves in the form of foreign currency assets, primarily sterling or dollars. On this basis, most countries, with China and the Soviet Union being notable exceptions, returned to a Gold Standard during the 1920s.

But many countries returned at the 'wrong' gold price/exchange rate. The UK, for example, returned at its pre- war rate. But a decline in UK competitiveness meant that sterling was now heavily overvalued. France, by contrast, having experienced higher inflation than the UK, returned at a different parity giving itself an undervalued exchange rate. The US did not change its parity but having experienced lower inflation than most countries this also resulted in an effective undervalued exchange rate. This led to large balance of payments imbalances, a situation which was exacerbated by central banks' unwillingness to co-operate and follow the 'rules of the game'.

This is something that Federal Reserve Chairman Ben Bernanke commented on in a speech in November 2010. He said: "the United States and France ran large current account surpluses, accompanied by large inflows of gold. However, in defiance of the so-called rules of the game of the international Gold Standard, neither country allowed the higher gold reserves to feed through to their domestic money supplies and price levels, with the result that the real exchange rate in each country remained persistently undervalued. These policies created deflationary pressures in deficit countries that were losing gold, which helped bring on the Great Depression. The Gold Standard was meant to ensure economic and financial stability, but failures of international coordination undermined these very goals."

The huge gold outflows that deficit countries were experiencing, most notably the UK, also undermined confidence in convertibility - an absolute necessity for the Gold Standard to function. This led to a run on sterling, eventually forcing the UK off the Gold Standard in 1931. With the widespread deflation and massive unemployment that came with the Great Depression, other countries, wishing to pursue inflationary policies and devalue their currency in a bid to boost competitiveness, gradually followed.

In the US, one of President Franklin D. Roosevelt's first acts on taking power in 1933 was to take the US off the US$20.64 per ounce parity it had held throughout the First World War and the 1920s. The dollar price of gold was gradually raised until it was fixed at the new parity of US$35 per ounce in early 1934. Most other countries, though, remained on floating or managed exchange rates until the outbreak of the Second World War.

2.3 The Bretton Woods system

It was clear during the Second World War that a new international system would be needed to replace the Gold Standard after the war ended. The design for it was drawn up at the Bretton Woods Conference in the US in 1944. US political and economic dominance necessitated the dollar being at the centre of the system. After the chaos of the inter-war period there was a desire for stability, with fixed exchange rates seen as essential for trade, but also for more flexibility than the traditional Gold Standard had provided. The system drawn up fixed the dollar to gold at the existing parity of US$35 per ounce, while all other currencies had fixed, but adjustable, exchange rates to the dollar. Unlike the classical Gold Standard, capital controls were permitted to enable governments to stimulate their economies without suffering from financial market penalties.

During the Bretton Woods era the world economy grew rapidly. Keynesian economic policies enabled governments to dampen economic fluctuations, and recessions were generally minor. However strains started to show in the 1960s. Persistent, albeit low-level, global inflation made the price of gold too low in real terms. A chronic US trade deficit drained US gold reserves, but there was considerable resistance to the idea of devaluing the dollar against gold; in any event this would have required agreement among surplus countries to raise their exchange rates against the dollar to bring about the needed adjustment. Meanwhile, the pace of economic growth meant that the level of international reserves generally became inadequate.

In 1961 the London Gold Pool was formed. Eight nations pooled their gold reserves to defend the US$35 per ounce peg and prevent the price of gold moving upwards. This worked for a while, but strains started to emerge. In March 1968, a two-tier gold market was introduced with a freely floating private market, and official transactions at the fixed parity. The two-tier system was inherently fragile. The problem of the US deficit remained and intensified. With speculation against the dollar intensifying, other central banks became increasingly reluctant to accept dollars in settlement; the situation became untenable. Finally in August 1971, President Nixon announced that the US would end on-demand convertibility of the dollar into gold for the central banks of other nations. The Bretton Woods system collapsed and gold traded freely on the world's markets.

3. Gold Market Drivers

Gold more of a financial asset when it comes to trading, even though 80-90% of the global production is used for jewlery and high tech areas like specialized electronics. Gold tends to have an impact on other precious metals like Silver and Platinum when they are not taking their cue from their own fundamentals/drivers. Gold will tend to dictate their price, and more on silver because platinum is more tiered towards industrial use.

Regarding the demand/supply equation, China has become the most important producer and has taken the spotlight away from Africa. But the real drivers of price fluctuations are actually very distant from the demand/supply equation.

a) the first thing to remember when trading Gold is that it spikes and collapses in a very violent manner.

Gold/SP500 ratio (weekly) showing how vicious the moves in Gold can be, relative to equites.

b) the second thing to remember is that Gold is quoted in USD, so it will tend to move opposite the DXY (Dollar Index).

Gold (Candles) vs. DXY (Bars)

c) the third thing to remember is that investors seek the "protection" of the shiny precious metal, and probably also call it "my precioussss", in times of adversity or "risk adversity".

Gold (Candles) vs. VIX Index (Bars)

d) Finally, we must also recognize how Gold is used as a hedge against inflation. So as inflation rises, so does the demand for Gold.

Gold MoM normalized % Change (orange) vs. US CPI MoM normalized % Change (blue)

Data Source: St.Louis FED

The main question that can arise is this: why does it seem that Gold follows each of the 4 main dynamics sometimes, whilst other times is does not? The answer is that like currencies for example, Gold does not trade on one single driver all the time. Depending on the state of the markets, each driver can come into play and then another one takes it's place equally as fast. That's why it takes time to master trading commodities (and currencies for that matter). But practice makes perfect: by frequenting our Live Trading Floor and liaising with fellow traders, it might be easier to grasp the dynamics of Gold quicker.

So what can we conclude? It might actually be safe to say that Gold does not trade on real fundamentals. This is not to say gold is not affected by "macro issues", but inflation, risk perception, anti-USD - they are very different dynamics than saying Gold has a fundamental value, an intrinsic worth. So Gold is not, and can never be, an investment vehicle. It has no true intrinsic value/cash flow/earnings/coupon/yield so it is more of a trading vehicle - which is great for our needs. With cases like this, it pays to develop a sturdy method to gauge which themes, headlines or drivers are influencing prices at any given time. In order to develop a real Sentiment analysis for Gold, it might be useful to pursue the Mindset Lessons/Trading 202 where these apparently complex issues are confronted with a more structured approach.

To sum up: Gold has been a protagonist for hundreds of years, and only recently has become a free-floating commodity. Trading Gold is not as easy as it might seem because it really doesn't trade on it's supply side fundamentals of production. It trades on macro issues and acts much more like a currency then anything else. In order to master these dynamics in a timely fashion, liaising with fellow traders on the Live Trading Floor and pursuing a more in-depth understanding of Sentiment can definitely help not get hit by Gold's tendency to spike and collapse.

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