What determines the gold exchange rate?

Traditionally, it has been stated that the price of gold tends to rise when inflation is high and fall when inflation is low. However, the relationship between gold and inflation is much more intricate due to the numerous factors that influence the price of this global commodity. Understanding these factors is essential as they play a complex role in determining the resulting price of this precious metal. Furthermore, some of these factors have the potential to provide insights into the short-term future development of the gold price.

Which market factors determine the gold price?

The main macroeconomic factors that determine the development of the gold price on global markets include:

• Global geopolitical events (risk off/on sentiment)

• US dollar, interest rates, inflation

• Central banks

Factor 1: Global geopolitical events - risk off / risk on sentiment

The global events of the Coronavirus pandemic and the invasion of Ukraine have had a profound impact on the world markets, creating widespread uncertainty and risk-off sentiment. However, intriguingly, the behavior of the gold exchange rate defied expectations in both cases. When the announcement of the Covid-19 pandemic was made, gold experienced a notable and sustained upward trajectory on the chart. Conversely, following Russia's invasion of Ukraine, gold initially exhibited a rise in the first two weeks after the conflict commenced, but subsequently weakened. This contrasting pattern can be clearly observed when examining the gold chart below.
 

_{The impact of the covid-19 pandemic and the invasion of Ukraine on the gold price}

The relationship between the gold price and global geopolitical events yields a more ambiguous conclusion. While uncertainty in the markets can occasionally drive an appreciation in the gold price, extreme risk aversion characterized by strong risk-off sentiment can actually weaken it. This is due to the fact that during periods of uncertainty, investors typically seek refuge in safe havens.

Historically, US government bonds have served as the preferred safe haven over gold. Unlike gold, these bonds provide investors with a return in the form of interest. Gold, being a non-yielding asset, does not offer a fixed return, thus impacting its attractiveness during risk-off episodes.

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Factor 2: US dollar, interest rates and inflation

The gold exchange rate, quoted in US dollars per troy ounce, exhibits an evident inverse relationship with the value of the US dollar. When the US dollar weakens, gold tends to appreciate, whereas a strengthening US dollar often leads to a decline in the price of gold. This relationship is clearly visible when analyzing the chart below, where gold is depicted in the top window and the USD index is displayed in the bottom window. The weekly chart provides a visual representation of this inverse correlation between gold and the US dollar.
 

_{Gold and USD index on weekly chart}

Following the Federal Reserve's decision to cut interest rates to 0.25% in March 2020 as a response to the impact of the Covid-19 pandemic, gold experienced a notable and robust appreciation, coinciding with a weakening US dollar. Subsequently, gold entered a phase of stability, exhibiting a relatively sideways trend. Adding to this observation, it is noteworthy that the loose monetary policy implemented by the Federal Reserve contributed to a rapid increase in inflation within the United States from April 13, 2021, to July 13, 2022.

In response to the increasing inflationary pressures, the Federal Reserve took decisive action in early 2022 by rapidly raising interest rates to curb price growth. The rate hikes commenced on March 16, 2022. Interestingly, during the initial stages of the rate hikes, inflation continued to rise, while the price of gold weakened. Concurrently, the US dollar appreciated as the demand for US Treasuries, offering higher interest rates, surged.

However, the dynamics shifted on July 13, 2022, as inflation began to decline. Despite the presence of a strong dollar, gold's depreciation persisted for a certain period. It was only in October 2022 that gold initiated a strengthening trend, coinciding with a significant weakening of the US dollar, while inflation continued its downward trajectory.

Gold's efficacy as an inflation hedge in the medium term is limited, making it essential to focus on the actions of the Federal Reserve and their impact on the currency to gain valuable insights into the potential evolution of gold prices.

Factor 3: Central banks

Central banks play a significant role in influencing the price of gold. During periods of robust economic growth and substantial foreign exchange reserves, central banks may seek to decrease their gold holdings. This is because gold, unlike bonds or deposits, does not generate any return, exerting downward pressure on its price.

Regarding Russia potentially selling its gold reserves to raise funds amidst financial pressures, it could impact the gold price. According to the World Bank, such a scenario could potentially drive the price of gold down to approximately USD 1,400 per ounce by 2030.

Conversely, the BRICS community is contemplating the introduction of a gold-backed currency. With sufficient gold reserves, if countries were compelled to pay for commodities in this gold-backed currency, it could compete with the US dollar. This could potentially lead to a depreciation of the US dollar while driving the price of gold higher.

Conclusion

In conclusion, the price of gold is subject to the influence of numerous factors, as outlined in this article. Gold is a complex asset, making long-term price prediction nearly impossible. However, in the short term, certain patterns can be identified to assist traders in their speculations. The primary driver of gold price dynamics lies in the actions of the US Federal Reserve and the value of the US dollar, highlighting their fundamental significance in shaping gold's trajectory.

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