The Hindu Business Line : Gold prices driven more by non-physical factors

IF you thought the cash market represented by physical demand supply fundamentals was the main drive of gold prices, think again. There are those who assert that physical market is important and may lend support to gold prices, but is not a market driver.

What then are the drivers of gold prices? Exchange rate, inflation, liquidity and risk aversion are the main drivers of gold prices, according to the econometric work done by Macquarie Research Commodities.

"Statistical modelling shows that especially exchange rate and inflation/oil prices can explain more than 90 per cent of the gold price," Mr Micheal Widmer, analyst, said.

The exchange rate has long been considered one of the main gold price drivers, partially because gold is used as a hedge against currency movements, but also because foreign purchasing power, and thus metals demand, rises when the dollar falls, the analyst pointed out.

Another motive to invest in gold is to buy a hedge against inflation.

However, there is a drawback in estimating the impact of official CPI figures on gold prices. The inflation data are published on a monthly basis and with a lag. Therefore, markets use proxies as early indicators of inflationary pressure. Oil prices have been reasonably good in predicting inflation.

Looking at possible energy-induced inflationary developments, the EIA said in its recent energy outlook that "prices for crude oil, petroleum products and natural gas are projected to remain high during the remainder of 2005 and through 2006 because of tight international supplies and hurricane-induced losses."

The West Texas Intermediate (WTI) crude oil is expected to average $57 a barrel in 2005 and $64-65 a barrel in 2006. Retail regular gasoline prices are expected to average $2.29 per gallon in 2005 and $2.43 in 2006.

This should keep upward pressure on prices high, the analyst pointed out.

As for risk aversion, gold prices have found support by safe haven investment, with political unrest in several regions in the world still high. For instance, the situation in Iraq is still precarious, while Iran's nuclear aspirations are uncertain. In the immediate context, ad hoc conflicts - such as the recent riots in France - have the potential to spark investor interest in gold.

Liquidity is also seen lending support to gold. In the US, liquidity has increased strongly since the Fed started to lower the Fed Funds target rate back in January 2001. Although US liquidity has declined because of strong nominal GDP growth and lower base money growth, it is still abundant.

With the aforesaid factors and changes therein impacting gold prices, small changes in either physical production or consumption and supply or demand are unlikely to make any significant dent either way on prices.

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