Gold prices and the relationship with uncertainty and Bitcoin, explained – Moneycontrol.com
By Kalpana Warrier on February 10, 2021
Articles headlining gold prices have always been around but news linking the coronavirus pandemic and gold prices was an unexpected and repeated occurrence over the last year. In fact, one could find frequent mention of gold prices and its connections to the COVID situation, either in terms of cases, deaths, lockdown or international travel, across multimedia. It has thrown the whole world for a loop and the uncertainty that has accompanied the spread of the disease has reinforced the need to have sound investment practices. Usually in very uncertain times, it is common to find that people have become more risk averse and start seeking financial safety more actively. With a loss of jobs, reduced income, overall decreased sales, etc., it is natural for individuals to choose safe investments which provide high returns or at least keep up with inflation when necessary.
When people start thinking about precautionary savings, they often think of it in the form of safe instruments like government securities and gold. Historically, gold has been trusted because it’s believed that it would always trade due to its intrinsic value as precious jewellery, use in medicines, dentistry and electronics. As expected at the onset of the pandemic, everyone rushed to purchase gold to hedge themselves against these uncertain times. The price of gold in turn reacted positively to the increase in demand indicating a positive correlation between gold price and the number of coronavirus cases, as countries around the world began initiating lockdowns and tightening measures.
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However in the second half of the year 2020, despite the increasing number of COVID cases, with no respite in sight, gold prices demonstrated a negative correlation with the number of coronavirus cases. As can be seen from figure 1, the correlation between the two variable flips in the latter part of the year. Given the crude relationship between gold prices and uncertainty, is the inverse correlation between gold prices and coronavirus cases necessarily counterintuitive?
Figure 1 maps the total number of coronavirus cases in the world and the daily price of gold as sold on the London Bullion market at 10:30 a.m. A sixth order polynomial approximation has been shown here. Source: ICE Benchmark Administration Limited (IBA) and Our World in Data, John Hopkins University
But why demand gold?
Before we further discuss the path of gold prices in the last year, let us take a few minutes to think about the factors that attract people to gold as an investment. For starters, the limited natural supply of gold leads individuals to believe that this precious metal would keep them safe even in their worst times. For example, during the 1920 German hyperinflation episodes when there was limited faith in the national currency, gold prices were found to not only keep up with the high levels of inflation but they also provided a hedge against market volatility. When inflation is very high, holding onto money or assets with low return would not be a good investment strategy, thus motivating individuals to purchase gold since it has a proven track record of growing in value.
Gold is essentially a hedging (safe bet) commodity. The underlying belief is that gold would always trade as there would always be a buyer and a seller who would be willing to pay its worth, thereby not debasing their wealth. However, if the economy is doing very well, it may be better to invest in the stock market since the return would be higher. But if the economy is not faring well, then the general perception is that gold is safer than the other listed investment options. This is why a negative relationship between the strength of the USD and gold prices is a well established fact where a strong US dollar which signals economic growth is accompanied by a weak demand for gold.
Usually by looking at the forecast of key economic indicators, an investor can predict how well gold as an investment would perform. The year 2020 saw a dramatic rise in gold prices which ultimately reached a peak in August’20. The emergence of this pattern, that had not been seen in the last few years, was, in part, due to the pandemic. However, this rise was not consistent across the year- in fact the growth in gold prices almost stagnated over the last few months of 2020, even though the increase in coronavirus cases did not stall.
This could be partially attributed towards the gradual opening up of most economies in the world as lockdowns ended and social distancing rules were eased to accommodate business. The increased probability of a vaccine, political climate etc. were also contributing factors that led investors to form positive expectations of the future. We can see from figure 2, how the treasury rates, considered to be risk free return, fell in the last few months of 2020 signalling a shift in the market towards riskier investments. This is because, when consistent growth is expected and uncertainty declines, then economic investments such as purchase of stocks/equities may perform better than gold, and definitely better than treasury bonds.
Figure 2 shows the 10-Year Treasury Inflation-Indexed Security, Constant Maturity and daily price of gold as sold on the London Bullion market at 10:30 a.m. Source: Board of Governors of the Federal Reserve System (US) and ICE Benchmark Administration Limited (IBA).
Any threat to gold for the safe keeping
Coming back to the question about the limited rise of gold prices in the latter half of 2020, it might be wise to reiterate that it’s actually the relationship between the price of a safe asset and the uncertain times that matters. Times are certainly getting more uncertain both due to the relentless spread of COVID-19 and the sudden political turmoil as demonstrated in the U.S. Capitol. But instead of buying more gold, this time the investors saw better return and safety in cryptocurrencies like Bitcoin (BTC) as evidenced by the unprecedented rise in the value of Bitcoin over this period.
Figure 3 displays the trajectory of gold prices and Bitcoin measured in U.S. Dollars over 2020. Source: ICE Benchmark Administration Limited (IBA) and Coinbase
Thus, unlike the olden times, gold prices didn’t rise during these turbulent times. This uncertainty rather reflected a steep upward tick in the bitcoin price, thereby fuelling the discussion on whether cryptocurrencies are replacing gold as the new safe haven. An important point to analyse would be why this is happening now and why not at the beginning of the pandemic. According to the VIX (volatility index), the uncertainty was highest at the beginning of the year 2020 when people were least prepared for the novel Coronavirus. Over time, especially with the ongoing vaccine discussions, people felt more in control and didn’t behave as risk averse as they did earlier, thereby indicating that they were willing to take on some risk in terms of investment in Bitcoin vis-a-vis gold, which is more likely to return higher payoffs.
FinTwit – What is mainly driving the gold liquidation today? Im not sure I fully understand. Thanks
— Raoul Pal (@RaoulGMI) January 8, 2021
I have to agree. The transfer of perceived utility from gold to BTC is happening faster than most of us expected.
— Bill Skidd (@BillSkidd) January 8, 2021
At least if gold goes to zero you can still make a nice necklace.— LoriSpechler (@LoriSpechler) January 8, 2021
Unlike gold, but similar to other fiat money, Bitcoin has no intrinsic value. And unlike most financial assets, the major risk that Bitcoin faces is the existential crisis at the hands of regulatory agencies. Since they are not backed by a government or central bank, their values are often driven by speculative interest, which might change when there is more mainstream adoption or if the speculative bubble grows too big to sustain causing a collapse. The Twitter thread in Figure 4 shows how some investment experts perceive the current preference for Bitcoin over gold.
In the past, people have moved away from gold because holding it in the physical form can incur heavy cost, a strong feeling especially amongst the millennials. Many Indian households prefer to buy it in the form of gold jewellery and then store it in safety lockers often at facilities provided by banks. A friction that the financial markets are trying to resolve now. With the dawn of the digital age and financial market innovations, people have started finding it more convenient to buy gold online as a financial asset. Gold in the digital form is much easier to maintain as the authenticity issues also reduce drastically. For example, the Government of India introduced the Sovereign gold bond scheme in which the government securities are denominated in grams of gold. In the year 2020, on festivals like Dhanteras where people traditionally buy gold or silver to bring them good luck, they purchased it online in the form of a financial asset.
The beginning of the year 2021 saw a steady decrease in the price of gold, and as discussed, this could be due to reduced uncertainty whereby investors are choosing riskier investments, belief that gold has gone beyond its fundamental values or simply reliance on other safe havens as investors are preferring the stronger US dollar and rising yields. Irrespective of the direction that gold price travels in, the only thing we know for certain is that, as an investment, gold will always remain in vogue.
This article was originally published in PolicySquare.