A world with two gold prices?

by: Georgette Boele

In my previous columns I indicated that demand for gold as a safe haven has decreased while demand for gold as a risky investment has increased. But this is something many investors probably do not want to hear. They point out that this was a year of many uncertainties. That is absolutely true. But if gold were nothing other than a safe haven, its ‘behaviour’ would have been different from what we have seen in recent years.

Since the end of 2004 the gold market has been open to a wide investment audience, which can now invest much more easily in gold. But investment horizons and objectives vary from one investor to another. Some investors buy gold as the ultimate safe haven. They purchase physical gold and keep this in a safe (at home or a banking institution). As long as this gold is held in the investor’s name, he is the contractual owner. Other investors invest in gold products that are backed by physical gold. In this case, each product must be carefully scrutinised to establish who is the ultimate beneficial owner of the physical gold and whether there are any additional risks. Still other investors speculate on fluctuations in the gold price. These products, however, are not always backed by physical gold. Examples are gold accounts and exchange-traded or synthetic products without physical gold backing. In short, investors can find a gold investment to suit any investment objective and any investment horizon.

Tip to read: our Precious Metals Outlook – Positive, but wait to step in

Investors who purchase gold as a safe haven tend to be patient investors, happy to take short-term price fluctuations in their stride. If they consider the gold price relatively attractive compared to the long-term outlook for the financial system, the economy and the financial markets, they will buy gold. But there are also many investors who want to earn money on the short-term movements of the gold price. They are chiefly responsible for the day-to-day swings in the gold price.

So what happened during the global financial crisis of 2008? When the financial markets came under mounting stress, the gold price rose as investors scrambled to buy more gold. This trend continued until the liquidity crisis reached its climax. At that point, some investors sold their gold and other investments in exchange for dollars. Clearly, in the circumstances, they considered cash more valuable than gold. But who exactly were those investors that decided to sell their gold at that time? Were they the ones who were holding physical gold in a safe in case the entire financial system would collapse? Or were they the short-term speculators in gold? The first group would think three times before parting ways with their gold. And though the system appeared to be on the verge of collapse, it had not yet actually done so. The main panic occurred among speculators who urgently needed to trade in their gold investments for ready cash.

Let’s now go a step further. Suppose there are two gold prices: one for physical gold and one for all other non-physical gold products. How would these two gold prices behave? In well-functioning markets that are free from panic, the price representing physical gold will probably rise less quickly (assuming a positive trend) and also be less volatile than the non-physical gold price. In times of financial crisis, however, the price representing physical gold will increase much faster than its non-physical counterpart. All in all, speculative demand for gold has made the gold price more volatile. In addition, gold is behaving less as a safe haven. When there is zero trust in the financial system, the only safe option for investors is still physical gold. In a world with two gold prices, the price of physical gold will predominantly behave as a safe haven. The other gold price, by contrast, will act more like a financial asset and can serve as an anti-dollar investment.

This is column appeared earlier in Dutch on Beleggersbelangen.nl (2 December 2019)