How Gold Affects the Forex Market

How Gold Affects the Forex Market

The commercialization of gold has its origins in ancient times, when this metal was a sign of wealth and social position; it was used primarily as a reference to establish the exchange rates among currencies.

The ¨gold standard¨ is a monetary system in which the values are defined as a determined weight in gold. Under this standard, the institutions issuing the money guarantee the backing of the bills of that amount in gold. In the past, the same was used to commercialize commodities and trade in other currencies. Those who defend this system argue it is more resistant to the expansion of credit and debt, since the money backed by gold cannot be created arbitrarily by the governments.  This would prevent artificial inflation due to the devaluation of a currency, and it supposedly eliminates the uncertainty of such currency.

But the gold standard began to show its weaknesses when an economy strengthened, and increased importing foreign services and goods. This would  empty out the gold reserves necessary for backing currency, reducing the monetary mass, followed by an increase in interest rates, and a slowed down economic activity leading up to a recession. Then, the low price on the merchandise would generate a massive buy from foreign countries, reverting the process. The oscillating patterns of peak and fall maintained until the bursting of the First World War interrupted the market flow and the free movement of gold.

After both Wars, the Bretton Woods Agreement (1944) was issued as a product of the resolutions made at the Financial and Monetary Conference of the United Nations, in which rules were set for commercial and financial relations between the most industrialized countries in the world. In this was decided to create a World Bank and an International Monetary Fund, and use the dollar as an international currency, fixing its value in terms of gold at 35 dollars an ounce (at that time the United States held more tan 60% of the gold reserves in the world). The Agreement expired in 1971, and by the year of 1973, the currencies of the most important industrialized countries started to flow more freely, controlled by the supply and demand forces that acted on the Exchange Market. New financial instruments appeared, the market was deregulated and the commerce freed.

In the 80´s, the technology opened new frontiers and the circulation of capital between countries accelerated, extending the continuity of the market throughout the time zones in Asia, Europe and America. Currency transactions shot up from around U$S 70 billion a day in the mid 80´s, to more than $2.5 trillion a day, two decades later. The combination of low margin and high leverage has changed the way in which the interbank market for currency operates. The Exchange Market, which before was exclusive for big investors and financial institutions, today is available for a single investor and not so big institutions thanks to the Internet and online brokers, with real time transactions and charts.

Gold in the Forex Market

In Forex, the symbol for gold is XAU. The price of gold is measured by its weight, and it refers to the value of an ounce in dollars. Transactions with the prices of gold are done the same way as with currencies, by two way or OTC (Over the Counter). This means, managed between two parties without the need of a third party to consolidate the trade.  These types of transactions are negotiated in a virtual manner, since they do not require the physical exchange of the commercialized merchandise, considering gold as “XAU,” as if it were just another currency. These operations are only done in regard to the United States Dollar (USD).

In general, when the price of gold increases, the value of the dollar decreases. For such reason, investors operate in gold to balance out their earnings and loses against the dollar. Also, since gold tends to maintain its purchasing power over time, investors usually purchase this currency to counteract the effects of inflation and the variations in the value of currencies. The purchasing power of many currencies has generally diminished as a consequence  of the impact of the increase in prices of commodities and services.

In the Exchange Market, some investors also purchase and sell gold due to speculations, trying to make profit from the small fluctuations in prices. Nonetheless, the price of gold is very unpredictable, since it is mainly used as a purchasing power reserve, and it is consequently subject to many monetary and psychological factors. Investing short term to make more profit than with other types of investments can be very risky.

Since it is used as a reserve, the price of gold is closely linked to how other alternative investments behave, how the currencies, bonds and stocks are. The price of gold tends to rise when in the middle of monetary instability and the fall of capital markets. Also events such as wars and natural disasters influence on the price. The price of gold has been rising due to a weak dollar and the unstable stock market situation. Nonetheless, its real price, adjusted by inflation, is today much lower than it was in the early 80´s. Either way the current trend is in the rise, since in the last five years the nominal price of gold rose from US$330 an ounce in April of 2003 to US$900 in early April of 2008.

The rising prices of gold can affect other currencies, specially those countries with the greater production of this metal. For example, Australia is the third highest exporter of gold, and Canada is the third major producer. Therefore, we may speculate with transactions in Australian or Canadian dollars waiting to become stronger as the price of gold rises.

In the forex market, gold is neutral, which means it is not connected to any particular country, and increments in its price influence the transactions in diverse currencies. The prices of gold are important catalyst in the forex market.

Currently there are five main gold markets, all of which are based off of New York, London, Zurich, Hong Kong and Sidney. Unlike stock markets, the price of gold is subject to the perception of some important brokers who communicate with each other and “set” the price several times a day. This process gives more stability to the given price offering points of reference which are updated according to how the supply and demand move. The fact that all markets are in different time zones, allows transactions 24 hours a day. The main currencies used in these transactions are the dollar and the euro. A while back the British pound was the dominating currency, it is not so today.

Gold plays an additional role, which is to serve as a purchasing power reserve. Even though it may be used in productive processes,  the more part of the demand of gold comes from its use as a reserve.

Reasons to invest in gold

1. Gold is not affected by inflation nor devaluation. Nonetheless, it does not lose its daily value like it happens with paper money.

2. Gold is considered as a wealth reserve. Gold has demonstrated to improve its value in times of crisis or war, when alternative investments tend to fall.

3. Gold is NOT under political control. No government can  influence on its price.

4. Currently, gold reserves are limited. This influences positively on its price, since it must rise when it is a limited resource.

5. It is an easy investment. It is a currency accepted globally and it does not present many difficulties to exchange, nor exaggerated taxes.

6. It is a safe and worthwhile investment. In 2009, up to now it has a return of about 17%.

7. Its main use is for reserves. There is very little gold for sale  since it is used as a reserve, therefore we may expect its price to continue increasing

8. It allows diverse forms of investments. Bricks, deposit certificates, future and options on gold, investment funds.

9. Gold is considered the best investment in times of crisis. Gold is considered a good liquid asset and its value always increases during these times..

10. It does not pay VAT (Value-Added Tax)

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