A primer on trading gold, part 1 - fundamental facts and modern history
This is part one of a series that I am writing about what I’ve learned about gold and how to trade it.
Gold can be a confusing asset to trade, as it has subjective intrinsic value and no cash flow. At least stocks and bonds have projected cash flows that can be translated into a final price that investors are willing to pay for, but gold has nothing to anchor its price to any particular level. Is gold a commodity or a currency? Is it a risk-on or risk-off asset? The answers are not clear cut. Because gold confounds so many investors and traders, I’ve found it to be a fun and profitable asset to trade.
In part one, I’ll go over the basic fundamentals and history of the gold market. Later posts will cover the factors that drive gold, discuss how gold can be a profitable trading and investment vehicle, and compare gold against bitcoin as a trading vehicle and store of value.
I remember when I was an FX trader at a bank, one of the desk heads would walk around quizzing traders on the currencies that they covered. To the Mexican peso trader, he would ask, “What’s the GDP of Mexico? What’s the size of the current account deficit or surplus?” If he caught a trader unaware of these basic facts, he would rip into him on the trading floor. Consider part one a summary of basic facts and history that every self-respecting gold trader should know. It won’t make you a more profitable gold trader, but it will save you when you get quizzed by a patrolling desk head or your gold bug uncle at Thanksgiving.
The World Gold Council estimates that 209,000 tons of gold have been mined over human history, putting the market cap of gold at roughly $12 trillion. They break down the uses of gold into the following:
Jewellery accounts for 46% (95,547t, US$6tn)
Central banks hold 17% (35,715t, US$2tn) as reserves
Bars and coins represent 21% (43,044t, US$3tn)
Physically backed gold ETFs hold 2% (3,473t, US$0.2tn)
The remainder, primarily industrial applications and holdings by financial institutions, is 15% (31,096t, US$2tn).
As an aside, Bitcoin maximalists use the $12T market cap as a target for where the bitcoin market cap can eventually reach, but my opinion is that the 46% in jewelry should be excluded, and therefore $6.5T (still 9x today’s Bitcoin market cap!) is a more appropriate target.
Outside of jewelry and being a store of wealth, gold has many uses in industry and everyday life due to its conductivity and malleability. It is used in dentistry for making crowns, bridges, and other dental restorations due to its biocompatibility and resistance to corrosion. In electronics, it is integrated into memory chips, connectors, and switches. Gold is virtually indestructible, which means that every ounce of gold that has ever been mined still exists on this earth.
Unlike cash in a bank account or a Treasury bond, gold does not rely on another party to make good on its obligation to repay its holder, making it the ideal store of value that can shield holders from debasement of fiat currency and financial repression. Gold’s high density relative to other elements makes it easy to store and transport a large amount of value in a coin or a brick. If all the gold ever mined was smushed into a cube, the size of the cube would be merely 22 meters on each side. Gold’s status as the world’s predominant store-of-value benefits from the Lindy effect - civilizations dating back thousands of years until modern times have accepted gold’s value, and therefore are likely to accept gold’s value for some time to come.
3800 to 4800 tonnes of gold are mined every year, increasing the supply above ground by roughly 2% per annum. This steady increase in supply does not make a perceptible difference for the average gold trader, but when combined with gold’s lack of interest or cash flow generation, it can result in investors shifting their preferences away from gold towards other asset classes during periods when fears of inflationary monetary policy are absent. If governments and central banks did not engage in the debasement of currency and financial repression, there would be little need for gold as a store of value. Unfortunately, history has shown that every government, civilization, and empire that has ever employed its own currency has destroyed the value of its money by fighting wars and spending and borrowing excessively.
Gold’s modern history
1929-34 and the problem with the gold standard - The financial excesses of the roaring 20’s gave way to the Great Depression of the 30’s. Prior to 1929, many countries, such as the US, United Kingdom, and other European countries, utilized the gold standard to maintain confidence in their currency. Many gold bugs today wax nostalgic over the days when currencies were on the gold standard, but in reality, the gold standard created untenable imbalances in the global financial system that eventually resulted in the UK and other countries abandoning it from 1931 onwards. The US followed the UK in 1934 by announcing the Gold Reserve Act of 1934, which raised the official price of gold from $20.67 to $35 per ounce, effectively devaluing the US dollar.
Countries that adopted the gold standard signed on to a policy that tethered their monetary supply to the amount of gold in the government’s coffers at any given time. The gold standard prevented policy makers from injecting or pulling liquidity from the financial system in response to economic and financial gyrations. The money supply, and therefore the economy, were prevented from growing unless new gold was found or if the country had a trade surplus that attracted gold payments from other countries. In the event of a gold shortage, the only ways a country could bring gold back to its shores were to increase interest rates or curtail spending, policies that would stifle economic growth. Many countries reacted in exactly this way during the Great Depression, exacerbating the severity and length of the downturn. In 1933, Franklin D Roosevelt even resorted to confiscating gold held in private hands with Executive Order 6102, which required US citizens to exchange their gold coins, bullion, and certificates for US fiat dollars. The policy intended to bring gold back into the Federal Reserve’s coffers to support the economy, but will be remembered as a black mark in the history of financial repression in America.
1971 - The collapse of Bretton Woods - After World War II, the US emerged as the largest holder of gold reserves in the world and had the strongest economy relative to war-torn Europe and Japan. The US held 20,000 metric tons of gold in its reserves, worth approximately $20B and representing two-thirds of the world’s gold reserves at the time. The US dollar was pegged to gold at $35, and the establishment of the Bretton Woods System pegged many of the world’s currencies to the dollar.
The following decades saw the value of America’s gold reserves dwindle due to excessive spending on domestic programs and the Vietnam war. The New Deal programs that were initiated in the 1930’s, such as Social Security, continued to require significant spending into the 1950’s and beyond. Larger spending bills included the GI Bill of 1944 (financial assistance for veterans), the Federal Highway Act of 1956 (huge infrastructure spending), the Food Stamp Act of 1964 (expanding welfare), Medicare and Medicaid in 1965 (health insurance for retirees and low-income earners), and a pair of education bills in 1965 that increased spending on education at all levels.
In addition to budget deficits, the US also started to accumulate trade deficits as the European and Japanese economies experienced dramatic recoveries. America’s relative economic dominance began to wane, and its hunger for international exports depleted its reserves of gold over time.
The pressures of America’s twin deficits on the Bretton Woods system were not lost upon speculators and foreign central banks. Other countries started to redeem their US dollars back into gold out of concern, while speculators started to bet against the US dollar in foreign exchange markets. By 1971, the year when Nixon suspended the ability for foreign governments to convert USD into gold at $35, gold reserves had dwindled to 8100 metric tones, approximately $10B.
Former Federal Reserve Chairman Paul Volcker served as Undersecretary of the Treasury for Monetary Affairs at the time, and played a pivotal but reluctant role in the decision-making process that led the closing of the gold window. In his memoir Keeping At It, he recalled the events at Camp David, the secret meeting where Nixon and his advisors shaped the policy decision:
Some excerpts from the book:
On August 15, 1971, President Nixon spoke to the nation from the Oval Office in a televised speech. He buried the announcement of the suspension of dollars into gold several minutes into the speech, after first introducing several tax and spending cuts. He sold the suspension as “stabilizing the dollar” and breaking free of “international speculators”. The foreign exchange and gold markets knew very clearly what was going on. Nixon had ended the fixed monetary regime of Bretton Woods and was starting the new regime of floating fiat currency that we live in today.
Volcker on the immediate aftermath of the announcement:
Over the next nine years, gold appreciated from $35 before the day of the announcement to above $600. During that time, the US experienced some of the worse inflation in modern history, while bond vigilantes sent yields on the 10 year Treasury to 16%. The price of gold didn’t stabilize until Volcker finally brought inflation under control, after which gold traded sideways to lower for two decades.
2000 to present - The era of easy monetary policy - Gold suffered from two lost decades from 1980 to 2000, but a new bull market emerged in the aftermath of the dot-com bubble. Fed chair Greenspan cut the Fed funds rate to 1%, a record low at the time. The US dollar depreciated against its trading partners as central banks that had accumulated large amount of US dollars (such as China and Saudi Arabia) started to diversify their holdings into other currencies. September 11 and America’s subsequent wars in Afghanistan and Iraq kept budget deficits from closing, and propelled the size of US debt relative to GDP higher. The rise of China and emerging markets also gave rise to a boom that lifted the prices of all commodities, including gold. The Great Financial Crisis of 2008 brought on the novel monetary tools of quantitative easing and negative interest rates, policies that were easy to implement but difficult to exit from. The confluence of these trends sent gold from a low of $263 in 2000 to a high of $1825 in 2011.
Now that we are in familiar territory for most readers, I’ll stop the history lesson here. One theme is clear - gold has been a hedge against expansionary monetary and fiscal policies. Part 2 of this primer will discuss the factors that drive gold, as well as the three regimes that tend to dominate gold price.
Disclaimer: The content of this blog is provided for informational and educational purposes only and should not be construed as professional financial advice, investment recommendations, or a solicitation to buy or sell any securities or instruments. The blog is not a trade signaling service and the author strongly discourages readers from following his trades without experience and doing research on those markets. The author of this blog is not a registered investment advisor or financial planner. The information presented on this blog is based on personal research and experience, and should not be considered as personalized investment advice. Any investment or trading decisions you make based on the content of this blog are at your own risk. Past performance is not indicative of future results. All investments carry the risk of loss, and there is no guarantee that any trade or strategy discussed in this blog will be profitable or suitable for your specific situation. The author of this blog disclaims any and all liability relating to any actions taken or not taken based on the content of this blog. The author of this blog is not responsible for any losses, damages, or liabilities that may arise from the use or misuse of the information provided.
Excellent summary