Why Have Gold Prices Rallied So Much Lately?

This is Breaking The Dollar, the podcast that dismantles some of the biggest misconceptions about money.

Presented by Gainesville Coins.

Hello everybody and welcome back to Breaking The Dollar I'm your host Everett Millman and today's episode is a pretty hot topic. We actually got more than one question from the listeners about this, so we just decided to do a whole episode on it and that is:

Why is the gold price rising so much right now?

Because if you haven't heard the news or seen anything on the financial news, gold is up about $300 this year. It's up like 30% which is really big and in fact this topic is so hot that I actually got to go to New York City and do a couple of interviews about this on TV.

So obviously this is something people are talking about and discussing and what's interesting is that there's not a lot of clear answers out there. I think there's a lot of confusion about what is driving the gold price.

So like anything else, it's not just simply one factor.

There are several different things that are kind of coincidentally all coming together at the same time that are driving what is really a fear trade into gold. And what I mean by that is there have been a lot of headlines recently about a coming recession sometime soon.

And that's not just, you know, some type of opinion. It's based on all of these different economic indicators and signals which are suggesting that we're probably gonna have a recession in the next, you know, nine to 18 months, probably sometime in 2020 maybe even 2021 if we get a little bit lucky.

So that begs the question, what does that have to do with gold? Why is gold more valuable during recession? Or why would it's price rise if we get a recession?

And kind of the most basic answer is that markets will be in turmoil. You know, the stock market would be very likely to go down.

Bond markets are kind of upside down right now.

And so as an alternative, as a quote unquote safe haven gold is the traditional or historical place that investors like to go for safety.

Because gold is held for the most part, it is outside of the rest of the financial system. It is a tangible asset. You know, it's a physical commodity. It's not something that's just on paper.

So even if the economy isn't growing and you know, stock prices are falling and companies are in bad financial shape, none of that is correlated with gold. So in part, it's really not so much about what's making gold go up, it's just this relative comparison that everything else is going down.

And so as that happens and more people start to buy gold, that's why you see the price rise. And as I said, there's a lot of these signs or signals that we're probably on the precipice of a recession.

And one of the most obvious ones that have really caught the media's attention is the trade war.

And we did a previous episode all about why the trade war matters and how it could have a really big impact on the global economy. So really all you need to know there is the trade war is still going on and even more so than that, the day to day swings in the market have been heavily dependent upon news about the trade war, so it's not just something going on in the background. It is very present in everyone's mind and it is causing a slowdown in global trade and global economic growth on top of what already looked like a gradual slowdown in manufacturing and growth around the world. So you can think of it kind of as fuel to the fire that the trade war is making, the chances of a recession even higher.

Aside from that, gold is not the only quote unquote safe haven out there. There are other traditional safe haven assets, primarily that's the u s dollar, the Japanese yen and US treasuries. People definitely like the safety offered by government bonds and the u s government is considered the safest. Well all of these other safe havens have already seen a ton of demand. They've already appreciated quite a bit and so that means those are pretty crowded trades. It's harder to get much of a return off of those safe havens when everybody else has already piled into them. And Gold seems to be absorbing that overflow of safe haven flight and safe haven demand. And so that's another reason why the price of gold has gone up so much this year. Another point that's often overlooked is that commodities generally follow cycles. They're kind of cyclical markets by their nature.

And over the past five or six years, gold has been in a definite downtrend. So there's a process called a regression to the mean, which basically means you are moving back toward the average. So if gold has been going down for five or six years, that generally means that it's sort of overdue to go back up in the next several years. So that's definitely at play right now. Another point that I like to focus on because it is so crucial and perhaps outside of everybody's consciousness or not something that we like to pay attention to on our day to day basis is that central banks have been engaging in stimulus measures in the sort of emergency level policies that are to help stimulate the economy. If indeed it starts to slow down or we start to enter a recession and it's not just one, it's basically every central bank in the world.

And although that sounds like, okay, that's the medicine we need or that that's going to boost economic growth, we've been kind of abusing those policies. We've been using them so heavily that they're, they're no longer having quite the effect that they used to and this means that it's gonna make the downturn or the next recession even more painful because we've been using these sort of stop gap emergency policies in order to forestall a recession. And back to my point about mean regression, that means that it's probably going to cause an even worse downturn on the other end. Related to this idea of what central banks are doing and how that's driving the gold price is that we have a lot of rhetoric going back and forth and a lot of infighting between the Federal Reserve, the United States, central bank and the u s government. Our policymakers in Washington have been putting a lot of political pressure on the Fed to do what it wants.

And what it wants the Fed to do is to cut us interest rates and to ramp up some of these stimulus measures. And if it's not obvious why that's a problem, it's that the central bank implements policies that tend to take effect with a time lag. You know, it doesn't immediately change the situation on the ground for the economy. It takes a year or even two years for it to be implemented. And so if you have, you know, politicians or you know, members of the administration in the White House demanding for certain policies to be put in place in real time, that kind of clouds the judgment and confuses the outlook for the Federal Reserve. And granted, I am not typically a defender of the Fed. I don't want to sound like I'm some type of apologist for the Fed. I already don't think that these policies are a very good idea.

But I understand that they are in a very tough position when they have all this political pressure on them. And the Fed is supposed to be an independent, a political institution. And again, if it's not clear why that matters or why that's causing these fears about a really bad recession, it's because it creates at least the appearance of political instability and instability is one of the main deterrence of foreign investment investors. Like some degree of certainty or stability, at least they want to know that the changing political winds are not going to radically alter the course being taken by the central banks policy. So again, although it is, uh, not as bad as a developing country, you know, a quote unquote third world economy where they tend to have very unstable politics. That same principle about why investors wouldn't want to put their money in that country are beginning to apply to the United States as well.

And so the final reason that gold prices are a really on fire right now has to do with counterparty risk and counterparty risk is basically the chance that your counterparty or the other party in a trade might default on their obligation. You know? So if you hold a bond, it's the chance that whoever issued that bond, whether it's a government or a company, they go into bankruptcy and they default on their obligation to pay you back. We don't see this very much in advanced economies in the developed world, but it's a non zero possibility. The chances are greater than zero. It could happen. That's what counterparty risk is. And the riskier an asset is, the more likely that counterparty risk will come into play. When you buy gold, you don't have any counterparty risk as long as you hold it yourself because there's no third party out there to default.

You own the gold. And this is one of the main reasons that gold does act as a safe haven, is that you don't have to trust anyone else. You hold the gold, you know what you have and theoretically nobody can take it away from you. And that kind of provides a nice transition into our question of the week from the listeners because as I said, it could have been the whole topic of this episode, but we had more than one person asked about why the gold price is going up. So I figured I would quickly address it and as I said, you know, I was focusing on they're not being counterparty risk with holding physical gold. I might not have made that distinction the first time around, but it leads us into our question.

It comes from Jesse in Saint Paul, Minnesota and Jesse asks, what is paper gold? How is it different?

And that is sort of the point that I am driving at is that physical gold is exactly what it sounds like. It is like an actual gold coin or gold bar that you can hold, you can touch and you own it. Most investors do not typically buy physical gold. That's not the main way that they buy gold. They either buy gold futures, which is a derivative product or gold ETFs and exchange traded fund, which on paper in theory is a third party that holds a bunch of gold in a vault and then sells off shares of ownership of that gold. These are the more popular mechanisms for people to gain exposure to the gold price and to invest in gold and that's somewhat understandable because paper gold is more convenient. You don't have to, you know, go and pick up the gold.

You don't have to lug it around. You don't have to come up with space to store it or put it in a vault and pay storage fees. You just have a paper asset just like any other financial asset, like a stock or a bond that you hold on paper and it represents the price of gold. Now, the reason that physical gold is in our view, preferable to forms of paper gold is that all of those types of paper gold I mentioned, whether it's gold futures or gold ETFs, they do still come with a measure of counterparty risk because although they are supposed to be a promise to deliver physical gold at a future date, that you're supposed to be able to either cash in your share of a gold ETF for whatever amount of gold that represents, or if you hold a gold futures contract to maturity, you can get physical delivery of gold.

That very rarely happens, almost never. And in the cases that it does happen, it is reserved only for very big financial institutions. So you basically have to be a big hedge fund or a government entity like a central bank in order to have your gold delivered to you. Otherwise, paper gold is always just settled in cash. And although that in normal circumstances, there's nothing wrong with that and you're still getting the dollar value of the amount of gold that you had intended to invest in. There is still the obvious and likely possibility that you are never actually delivered your gold. And let's say there is a sort of run on the bank, let's say a lot of people are trying to cash in their ETF shares or futures contracts all at once because again, it's not totally unlikely. Let's say there's like a panic and people realize they want to have the physical gold in their possession.

That raises the chances that you never get to see that gold and there's none left for them to give you, in which case they're really not obligated to pay you out the cash amount because the gold is gone. So those are the differences between physical gold and paper gold. And it's an important distinction for the audience to understand because not many people out there are talking about it. They think all forms of gold are the same and in fact they tend to overemphasize those drawbacks about physical goal that I mentioned before. But even when that's the case, at least the liability is in your hands. At least you don't have to trust someone else, like a bank or some third party to protect your gold for you. So as always, thank you so much for listening. I hope this week's episode was informative and be sure to join us on next week's episode where we take a look at some of the biggest gold heists in history.

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The views and opinions expressed on this show are for informational purposes only and should not be used or construed as professional investment advice.