Gold: Two critical fundamental drivers and the importance of 1250

February 19, 2016

After residing in traders’ doghouses throughout all of last year, everyone’s favorite yellow metal has been on much better behavior thus far in 2016.

As we’ve noted before, the price gold is determined by the interaction of supply and demand, as with any commodity. While the supply of gold is relatively predictable in the short term, the demand for gold is not driven by the conventional industrial demand that drives most commodities. Instead, gold demand is driven primarily by its attractiveness as an investment, which is in turn driven by real interest rates and the value of the US dollar.

Fundamental Driver #1: Real Interest Rates

Real interest rates simply represent the opportunity cost of holding gold. When real interest rates are low, investment alternatives like cash and bonds tend to provide a low or negative return, pushing investors to seek alternative ways to protect the value of their wealth. On the other hand, when real interest rates are high, strong returns are possible in cash and bonds and the appeal of holding a yellow metal with few industrial uses diminishes. Beyond the opportunity cost of holding gold, interest rates also play a role in the cost of funds when buying gold on margin, as many traders do. One easy way to see a proxy for real interest rates in the United States, the world’s largest economy, is to look at the yield on Treasury Inflation Protected Securities (TIPS).

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