Demystifying the Gold Rally

Gold on Feb 1, 2020: Rs. 42,360 per 10 grams

Gold on August 8, 2020: Rs. 57,415 per 10 grams

35.5% increase in 6 months

What’s causing it? Let’s take a look.

Cause 1: Flight to safety

There are multiple asset classes one can invest in: Equities, debt, commodities, and currencies. The price movement pattern of each asset class is different — some are inherently more volatile (for ex — equities) and others are relatively stable (for ex — debt and gold).

During times of stress in the financial markets (such as the COVID-19 pandemic), these patterns become more pronounced. Equities become highly unpredictable and volatile while assets such as gold are thought of as safe havens (i.e. due to low downside risk).

During times of crisis, investors start allocating capital to safer assets, primarily gold, to provide stability to their portfolios (referred to as a flight to safety). As demand for gold rises, so does its price. The same happened during the financial crisis of 2008 and the uncertainty in the following years.

Gold prices in 2008: Rs. 12,500 per 10 grams

Gold prices in 2011: Rs. 26,400 per 10 grams

111.2% absolute returns in 3 years (28.3% annualized returns)

Cause 2: Inflation fears

During periods of turbulence, central banks often cut rates and governments stimulate the economy by increasing spending. Rate cuts lower the cost of borrowing, encouraging people to borrow more and ultimately, consume and invest more. Government increase in spending ultimately flows to the people as income. These measures are meant to revive demand. However, excessive demand can lead to inflation, requiring that the quantum and mode of delivery of the measures taken by the central bank and the government be tightly regulated.

In the financial community, gold is considered as a hedge to inflation. So, is the fear of inflation leading to a rise in demand for gold? Not quite. Inflation fears are restricted due to the huge demand shock caused by COVID 19 and the subsequent lockdown. So inflation fears explain only a part of the increase in demand for gold.

What really matters is that as rates are cut, the returns available on debt instruments also decrease. Hence, out of the two safe havens of debt and gold, people start preferring gold. It’s really about the fact that the opportunity cost of investing in gold reduces significantly.

Cause 3: Herd mentality

The tendency of humans to join a trend is well documented. As gold prices start rising, more and more is written in the media. This is equally true for all assets, not just gold (you must have come across headlines such as — this stock has delivered 340% returns in the past 2 years!). As coverage about the price rise increases, more investors jump on the bandwagon, pushing the price of the asset even higher (in some cases, the euphoria may even lead to asset price bubbles).