Michael G. Martin
Worldwide attention has recently been focused on the gold market as the level and volatility of gold prices have increased markedly. Between September 1978 and January 1980, gold prices increased almost fourfold from US$217 an ounce to $850 an ounce (see the chart). Subsequently, profit taking set in and gold prices eased to around $500 an ounce by the end of March, but soon began moving higher again, reaching $600 early in June and about $680 by mid-September.
What makes the rise even more notable is that it occurred during a period of relative strength for the U.S. dollar in international exchange markets. Previously, the increase in gold prices was often largely a reflection of the weakness of the dollar. From the end of 1976, for instance, through September 1978, the price of gold in terms of the U.S. dollar increased by 61 per cent as the dollar weakened against the major European currencies. (The U.S. dollar fell by 58 per cent against the Swiss franc, for example.) From September 1978 through January 18, 1980, however, the. price of gold rose by 285 per cent in terms of the U.S. dollar, despite a fairly stable dollar. Moreover, the price of gold rose over this period in terms of other currencies too, increasing by 242 per cent against the deutsche mark, 296 per cent against the Swiss franc, and by 387 per cent against the Japanese yen.
At the same time as gold prices were rising, their volatility was increasing. Prior to mid-1978, prices generally fluctuated on a daily basis within a range of $1 or $2 per ounce. Since mid-1978, however, they have generally moved by many times that amount—over one 24-hour period in early January 1980, for instance, the price of gold declined by $113 an ounce.
Factors affecting both the demand for and the supply of gold worked in concert to bring about the marked increase in prices after mid-1978. On the demand side, speculative demand for the metal rose sharply. Admittedly, it is difficult to quantify speculative demand, but it seems, according to Consolidated Gold Fields (an authoritative market source), that speculative demand rose to around 14 or 15 million ounces in 1979, up from about 5 million in 1978. Since speculative demand for gold rises only if the expected increase in gold prices is greater than the expected return on other investment mediums, this steep increase seems to have been a response to accelerating world inflation and market expectations of an impending currency crisis. Inflation was increasing, particularly in the United States, where the consumer price index rose by 14 per cent in 1979, and seemed resistant to policy approaches to deal with it. At the same time, other traditional investments, such as stocks and bonds, were performing poorly in most countries, so investment vehicles like gold—which previously were looked upon as esoteric and too risky—began to be more attractive to investors. Even some mutual funds, for example, now allot a certain proportion of their portfolios to gold, something that was almost unheard of just a few years ago.
Political turmoil in the Middle East with its implicit threat to world stability also contributed to the demand for gold. On the one hand, residents of the countries most immediately affected liquidated domestic investment assets and purchased gold as a more politically safe investment. On the other hand, the crisis caused—as crises usually do—a general increase in the price of gold, presumably because investors viewed the metal as an investment of last resort in the event of a collapse of the international financial system. Expectations of a reduction in official sales to the market also fueled demand, as did the fact that the European Monetary System (which came into force early in 1979) accorded gold a role, making it usable by means of conversion into European Currency Units (ECUs). And the demand for official coins, amounting to about 9.3 million ounces, continued to be strong in 1979.
The aggregate demand for gold was essentially unchanged at about 56.8 million ounces in 1979, due to an offsetting decline in demand by jewelry manufacturers and industrial users, which was particularly evident in the developing countries—especially in the Middle East. This fall in industrial and jewelry demand was of course the result of higher prices and, in fact, it is surprising that demand fell as little as it did, by about 22 per cent in 1979, in the face of a 132 per cent increase in prices. (It should be noted though that the main price increase occurred after the main purchase season of the jewelry trade was over.) In 1974 when prices rose by a lesser amount (66 per cent), demand fell much more abruptly, or by about 45 per cent. This recent stability of industrial demand is largely attributable to the fact that in 1974 the substitution of gold in industrial processes was pushed so far that at the current higher prices very little room for additional substitution exists.
Part of the rise in recent bullion prices was attributable to curtailed supplies to the market. The production of South Africa, which contributed 73 per cent of Western output last year, and the output of other countries declined slightly in 1979. South African production fell to 22.6 million ounces in 1979 from 22.7 million ounces a year earlier, due to the mining of lower grade ore. Sales from member countries of the Council for Mutual Economic Assistance (CMEA), predominantly from the Union of Soviet Socialist Republics, which were estimated at about 13.2 million ounces in 1978 (the highest level since gold began to be freely traded in 1968), were reported to be considerably lower in 1979, at around 7.4 million ounces. The lower level of Soviet sales in 1979 probably stemmed in part from the sharp rise in the prices of gold and oil exports which thereby eased their need for foreign exchange. In addition, the unusually high level of Soviet sales in the period 1976–78 may have diminished the level of their stocks to an undesirably low level.
While Soviet gold sales declined, a sharp increase occurred in the monetary sales by institutions such as the International Monetary Fund and the U.S. Treasury, whose combined monetary gold sales amounted to about 17 million ounces in 1979—representing about 30 per cent of aggregate supplies. Actual and anticipated changes in monetary supplies of gold to the market clearly exerted upward pressure on bullion prices late in 1979. The United States ceased gold sales altogether in November 1979. This action, in conjunction with market awareness that the Fund’s gold sales program was scheduled to end in May 1980, caused a fundamental change in market expectations concerning prospective supplies late in 1979 and helped lead to the sharp rise in gold prices during that period.
As mentioned earlier, the sharp rise in gold prices occurred at a time when the value of the U.S. dollar in international foreign exchange markets was relatively stable. The movements of the dollar reflected a combination of circumstances that tended to stabilize its value in exchange markets. First, the inauguration of the dollar-defense program in November 1978 by U.S. authorities helped to reduce fluctuations. The program principally entailed a tightening of domestic monetary policy (including a sharp increase in the Federal Reserve’s discount rate), an increase in monthly gold sales by the U.S. Treasury, and, most important, the announcement of measures that could mobilize the equivalent of $30 billion in foreign currencies for intervention purposes.
In addition to these measures, the disruption in oil supplies and the sharp increase in oil prices early in 1979 led investors to move into the dollar and out of European currencies and the Japanese yen, which they expected to be more adversely affected. Finally, this trend was strengthened as higher inflation rates in countries that previously had strong currencies, such as the Federal Republic of Germany, Japan, and Switzerland, caused many investors to alter their view of these currencies as sanctuaries from currency depreciation.
An analysis of gold price movements shows a distinct increase in volatility recently, with day-to-day and month-to-month price changes, both in absolute and percentage terms, markedly higher than during the earlier period. The average monthly standard deviation of gold prices rose from $2.17 per ounce in 1977 to $4.95 per ounce in 1978, and to $10.46 per ounce in 1979. The increase was more pronounced in late 1979 when the deviations for September, October, and December—$23.57, $14.48, and $28.05 per ounce, respectively—were the highest on record. The difference between monthly high and low prices has also risen markedly, averaging $24.27 per ounce for the period June 1977-December 1979 against $9.70 per ounce for the period May 1976-May 1977.
The daily percentage price change—another measure of price variability—confirms the marked rise in gold price volatility. Whereas from January 1975 to September 1978, gold price changes on a daily basis varied by 2 per cent or more on 8 per cent (76 occasions) of the observations, the figures for the period October 1978 through March 1980 were considerably higher, namely, 30 per cent (112 observations) of the time. Further, in the latter period, 8 per cent (26 occasions) of the daily observations involved price changes in excess of 5 per cent compared with less than one half of 1 per cent (4 occasions) for the former period.
In a period of sharply rising prices, relative and absolute changes tend to overstate the magnitude of volatility. For a clearer picture, it is also necessary to look at a measure of price volatility that leaves out the trend. Such a statistical measure, examining deviations around a five-day moving average, was therefore used, and it corroborated the results of the other measures.
As the volatility of gold prices increased, numerous institutions in the gold market amended their procedures. Late in its auction program in 1979, the U.S. Treasury increased the deposit requirement at its auctions to $30 an ounce; in addition, the New York Commodity Exchange raised its margin requirements from $1,500 to $3,000 per contract. Based on a gold price of $800 an ounce, the new margin requirement represented about 4 per cent of the value of the gold purchased. The daily permissible price movement on the New York Commodity Exchange was also increased from $10 an ounce to $20 an ounce in recognition of the increase in gold price volatility.
Many factors contributed to the rise in gold price volatility. These factors are similar to those affecting the price itself, with a sharp increase in speculative demand perhaps playing the largest role. Speculative demand, of course, is more volatile than industrial demand. The speculative demand for gold is potentially destabilizing since gold does not yield a rate of return to the holder unless its market value rises.
However, although the abrupt rise in price volatility in the gold market seems to correlate well with a sharp increase in speculative activity, the strong correlation between the two does not necessarily imply causation. Speculation need not necessarily be destabilizing. Speculation in commodity markets can be, and in fact often is, stabilizing. For example, if speculators more or less correctly anticipate future price movements, the effect of speculation would be to diminish large price changes. Speculation, however, can be destabilizing if speculators are wrong in their anticipations, and this seems to be what has happened recently in the gold market. Essentially, destabilizing speculations can be classified into two basic types. First, there is “mistaken” speculation, which occurs when speculators expect the price to rise when in fact it falls, and vice versa. Second, there is “excessive” speculation, which occurs when speculators anticipate the direction of the price change correctly but overestimate the magnitude of the change. Thus, to the extent that rising prices engender expectations of further price increases and price declines expectations of a prospective fall in price, changes in speculative demand tend to be self-perpetuating and to exaggerate price movements. The latter type of destabilizing speculation, in particular, appears to have occurred in the gold markets in 1978 and 1979.
More factors in volatility
Futures trading in gold, which has increased dramatically to dwarf spot trading, may also have led to increased volatility. Trading volume on the major U.S. futures exchanges grew to about five million ounces a day by the end of 1979, up from about 400,000 ounces a day at year-end 1975. The expansion in the size of the futures market has given speculators a new and more attractive vehicle, and this may have increased price variability. In the futures market, of course, speculators exercise much more leverage in their investments than in spot market transactions.
Just as it contributed to the generally higher trend, the recent increase in uncertainty surrounding the market has also contributed to greater price variability. Turmoil in the Middle East, uncertainties concerning the price and supply of petroleum, and prospects of changes in inflation rates led to frequent reversals in the outlook of investors and consequent changes in their positions in the market. Since the gold market is also very sensitive to actual and expected changes in currency values and interest rates, it is not surprising that the general unstable underlying economic conditions recently have led to enhanced gold price variability.
|Net trade with CMEA countries||−0.1||1.7||6.8||8.8||7.1||4.8||13.2||12.9||13.2||7.4|
|Net official purchases (−) or sales (+)||−7.6||+3.1||−4.9||+0.2||+0.6||+0.3||+ 1.9||+8.6||+11.6||+18.5|
|Use of gold|
|Jewelry and industrial2||42.8||42.9||41.2||25.9||14.4||23.5||38.5||41.0||42.1||33.0|
|Net investment and speculative purchases (+) or sales (−)||−11.0||−0.1||−3.2||+ 17.4||+ 16.5||+4.2||+ 1.9||+7.1||+4.9||+ 14.5|
Excluding production in Council for Mutual Economic Assistance countries.
Including medals, medallions, and false coins.
Excluding production in Council for Mutual Economic Assistance countries.
Including medals, medallions, and false coins.
Another factor contributing to price instability is the very high ratio of stocks to flows in the gold market. Private and official gold holdings are large in relation to current production; official holdings alone represent about 35 times the annual current production. Consequently, relatively small shifts in expectations concerning changes in stock levels tend to engender large price movements.
In this connection, marked changes in actual and anticipated official gold sales have played an important role in increasing gold price volatility. The amount of gold sold officially by the U.S. Treasury and the Fund rose to 17.2 million ounces (excluding noncompetitive sales by the Fund) in 1979 from 10.0 million ounces in 1978, an increase of 72 per cent. Sales by the Fund were quite stable over this period, but the amount of gold marketed by the U.S. Treasury varied considerably. Market uncertainty was heightened by the U.S. Treasury substantially varying the amounts offered for sale during 1979—a deliberate policy aimed at keeping speculators off balance.
The entrance of a large number of new market participants with no previous experience in the gold market may also have added to volatility. Although no one can be sure, purchases from the Middle East may have become quite sizable in the last year. If these purchases were made for speculative purposes, they would have exerted upward and downward pressure on prices. Large numbers of small, so-called “unsophisticated,” investors purchasing gold coins have also joined the market, particularly in the United States, where residents are beginning to take advantage of the lifting of the ban on gold ownership in 1975.
Since a change in the monetary role of gold clearly affects the overall picture of supply and demand, gold prices are directly affected as the market expects the monetary role of gold to rise or fall. In 1975 the Interim Committee of the Board of Governors of the Fund reached a consensus that the role of gold in the international monetary system ought to be gradually reduced. This clearly affected the outlook of the market concerning the future of gold. Subsequently, however, expectations have been revived that the monetary role of gold will not be diminished significantly in the near future and perhaps may even increase. This revival is in part a result of the role accorded to gold in the European Monetary System.
The sharp changes in the amount of gold sold by the U.S.S.R. have added to price volatility as they raised prices (see the table). The U.S.S.R. seems to determine its gold sales policy according to its need for foreign exchange, which in turn has largely depended on the level of its primarily agricultural imports. Consequently, the abrupt changes from year to year in Soviet agricultural output have led to sharp variations in the amount of gold offered for sale. In 1979, as we have seen, Soviet gold sales fell sharply to about 7.4 million ounces from 13.2 million ounces in 1978. In addition, as mentioned, the rise in the price of gold, as well as oil, allowed the Soviet Union to reduce the volume of gold it marketed while not suffering a loss in revenue.
The recent increase in the price level for gold and its volatility should be considered in its historical context. The price of gold rose sharply in the early 1970s—from around $45 an ounce at the end of 1971 to almost $200 an ounce by the end of 1974. After a decline in 1975 and 1976, the gold price resumed its rise to around $800 an ounce by year-end 1979. By the end of 1979 the price of gold was 1,385 per cent higher than it was in 1926. It must be remembered, however, that the prices of many other products have also risen by about this amount: prices for lumber and wood products, for example, rose by about 1,200 per cent over the same period. So the recent marked rise in gold prices can be seen as a reaction to the maintenance of the official price of gold unchanged at $35 an ounce from 1934 to 1971, while other prices were rising. The unchanged price of gold meant that the real price in constant dollars fell by 75 per cent from 1934 through the early 1970s. Since the early 1970s, the price of gold has been going through a period of adjustment in re-establishing its value in relation to other commodities, partly as a result of its changed monetary role, and partly as an instrument for speculation. The recent rise in the level and volatility of gold prices was thus a direct result of its previous history.