Gold prices have risen strongly in 2016, appreciating around $300 per ounce since the start of the year. Gold demand has risen along with gold prices this year. In Q1, gold demand reached nearly 1,300 tonnes according to World Gold Council data, a 21% increase over the same quarter last year.
Nearly half of that demand (47.8%) came from the investment markets. And much of that demand was driven by exchange-traded funds. In the first quarter, gold demand from ETFs topped 363 tonnes, representing more than 28% of the total demand for the quarter.
An article in Barrons August 1 edition noted the success of gold ETFs have booked so far in 2016. (See Gold ETFs Wont Lose Their Luster This Year.) Globally, gold ETFs hold over 2100 tonnes of the precious metal. One ETFSPDR Gold Shares, marketed by State Street Global Marketsholds 43% of that gold.
The Barrons article states that the popularity of gold ETFs since 2011 (measured by fund flows) have mostly overlapped with the increase in gold prices during that time. Whether ETF flows are driving gold prices or merely following them is hotly debated. In reality, both claims can be true, depending on market conditions.
In the current economic climate, market conditions appear to be the primary driver behind the rising interest in gold among investors. Investors typically turn to gold as a store of value when interest rates decline or inflation rises. Right now, both forces seem to moving in a way that would help support a continued rise gold prices.
First, its well documented in the financial press that interest rates around the globe are on the downswing this year. Most notably, longer-term government bonds in Japan, Germany, France, Switzerland and other advanced economies have dipped into negative territory.
This is significant because global financial markets have never been here before. Negative interest rates have existed only in theory before, in the realm of economic textbooks. The outcome of these negative interest rate policies is largely uncertain, even among economists and market experts.
Ultimately, low and negative interest rates discourage saving. There is no incentive to keep money in a savings account if youre paying a bank for the privilege to do so. When savers dont earn anything on their deposits, they look elsewhere for a stronger store of value. And gold has traditionally fit the bill.
Then theres inflation. Throughout much of the current economic recovery, inflation has been mild and even non-existent. This was especially true in 2015, when declining oil prices reduced inflation to its lowest levels since the preceding recession.
The story has been much different in 2016. Oil prices have risen, giving inflation rates a jolt consumers have not seen since 2014. The core inflation ratewhich excludes volatile energy priceshas been above 2% for the past eight months, a trend not seen in at least four years.
The combined forces of low interest rates and higher inflation will put a continued squeeze on savers. Not only will they earn next to nothing on their deposits at near-zero yields, the little they do earn may be reduced further by higher inflation. In this scenario, gold will remain an attractive alternative for investors.
Is there potential for this situation to reverse? At the recent Federal Open Market Committee meeting on July 27, the Federal Reserve opened the door to a Fed rate hike later this year. As of this writing, the markets seem to expect rates to rise between 25-50 basis points at the Feds next meeting in September.
But on a global level, rates appear to be moving in the other direction. Australias central bank lowered rates to a record low of 1.5% on August 2nd. And last week, the Bank of Englanddropped their already-low rate to 0.25% in an attempt to resuscitate the U.K. stalling economy in the wake of the Brexit vote.
Even if interest rates rise in the U.S. later this year, inflation may also tick higher and continue to squeeze real returns for savers. Tighter labor markets have led to an increase in wages for U.S. workers this year. And it appears that these workers are spending their higher wages tooconsumer spending remained robust in Q2 and was the only factor contributing to the tepid pace of economic growth in the 2nd Quarter as well.
Higher wages and greater spending generally place upward pressure on inflation. So its likely savers will continue to feel the pinch from low real rates of return. That should help gold maintain its attractiveness to investors and keep gold demand and prices elevated.
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