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Gold and its role in financial markets

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Gold and its role in financial markets

October 09, 2018

For a commodity, gold is a curious precious metal. If we are to think of the history of money, we must think of gold as it is the only form of money that survived the test of time.

And, by time, we mean a few thousands of years.

Gold always fascinated people. Its unique properties made it desirable since ancient times, and the same desire drives people towards it to this day.

Until recently, gold played an essential role in the international financial system. Central banks used to back the money supply in circulation with a certain amount of gold held in their vaults

This way, they controlled inflation and made sure the population trust the money issued. After the Second World War, the worlds’ nations gathered in the United States to set the stage for a new monetary order.

The now-famous Bretton Woods conference led to the birth of the International Monetary Fund (IMF) but also pegged the value of the USD to gold. An ounce of gold was valued at $35, and the United States vowed to exchange all dollars for gold upon redemption.

Long story short, it couldn’t do that anymore, and in the 70’s it dropped the pledge. Since that moment on, major central banks around the world cut the gold standard too.

The last vital bank to do that was the Swiss National Bank (SNB) somewhere at the start of the years 2000, as it still had a fraction of its money supply tight to gold.

While no part of the current monetary system, gold still has something that determines people, as well as financial institutions, to want it. What is that?

Gold as a Safe Haven

It all comes down to trust. Governments issued their own money, or paper money (a.k.a. fiat currency). The Forex dashboard as we know it today reflects the fiat money around the world.

Effectively, these are nothing but electronic money in a bank account or banknotes bearish specific safety elements, so that is difficult to counterfeit. And, the central banks around the world make sure to control the quantity of the money circulating by draining it or expanding the monetary base.

To do that, they use inflation as a gauge. When inflation ticks to the upside or prices increase, central banks raise the interest rate level.

In doing that, they stimulate commercial banks to park their excess reserves in the central banks’ vault, in exchange for a higher interest rate. Thus, they drain liquidity, keeping things under control.

In a recession, central banks ease the monetary policy by lowering the interest rate level. Thus, commercial banks find it difficult to keep the money in overnight deposits at the central banks, so they are stimulated to invest the excess reserves in the economy and to lend money to the population. This way, the monetary base expands.

But this two-ways, bi-directional process, works only if the trust exists. On one side, commercial banks trust that the central bank will pay that interest and the money won’t depreciate in the meantime more than the interest paid.

On the other hand, population trusts commercial banks to place money in deposits and not fear the money will lose value.

This process has a measurement unit. Central banks act on interest rates depending on how much inflation deviation from the two percent target.

Higher inflation than two percent ends up in central banks raising the rates. Lower inflation sees the central banks easing the rates.

As long as this balance around two percent holds, the trust is there. This is, if you want, the equilibrium level.

When it breaks, the trust is broken. And what do investors, as well as people do? They turn to the only form of money known for ages: gold.

When Things Go Wrong

A quick look at what is happening these days in Argentina and Venezuela is enough to make any investor, retail trader or institutional, to question the central banking system.

Of course, that no one will tell population things to go wrong, but what if they do?

In parts of the world where the governments have a long history of misleading people, the trust is lost anyway as generations and generations have been ripped off by various politicians. As such, traditionally, families invest in gold by buying jewelry. Think of India and countries throughout Middle-East.

Gold is viewed as a safe-haven and an alternative to currency debasement. Sometimes, governments are forced to “let the currency go” as economists argue that a lower currency stimulates exports.

While that might be true, it also “dissolves” savings and peoples fortunes. Sometimes, overnight.

Hence, to protect against it, people and investors turn to gold, just as a hedge against the doomsday. You can also trade CFD's on gold, but before you do that, you should first compare CFD brokers.

If the Venezuela and Argentina cases weren’t enough of an example (in Argentina interest rates are at about forty percent while inflation in Venezuela increased thousands of times in the last years), Turkey makes headlines recently too.

The Turkish Lira (TRY), one of the currencies popular among retail traders due to its high volatility, dropped from 3.4 to almost 5 against the USD. And, the entire move happened in less than a year.

If you calculate the percentage, the wages or population income should have increased the same, and, at the same time, as the prices for goods and services increased (inflation jumped above the twelve percent level). However, they didn’t, and people just watch their money losses value in virtually overnight moves.

Turning to gold is normal. At the same time as the Argentina, Venezuela, or Turkey crises escalated, the gold price in local currencies exploded higher. Hence, the safe-haven role of gold, once again, did the job of protecting against currency debasement.

Conclusion

To this day, central banks around the world struggle to accumulate more and more gold. Recently, a wave of gold repatriations started, with Germany and the Netherlands repatriating gold from other central banks’ vaults.

China and Russia are known as gold buyers for some time now. Is it something in the making for the world’s monetary order?



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CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74-89% of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

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