Gold is a leading economic indicator, and the changes in gold prices can explain investor sentiment about the state of the U.S. and world economies. An increase in gold prices typically signals that the U.S. economy is struggling. Factors that contribute to an increase in the price of gold include a weak dollar, an increase in inflation and low interest rates over the long term. Individuals interested in investing in gold should understand the relationship between the price of gold and important economic factors.
The U.S. dollar is considered the world’s reserve currency, and an inverse relationship exists between gold and the dollar. As the dollar weakens, the price of gold increases. In contrast, the price of gold decreases as the dollar strengthens. The dollar is considered strong or weak in comparison to its trading against other currencies. For example, when the dollar is weak against the Japanese yen, it means that the dollar is exchanged for a decreasing amount of yen than in the past. As the dollar continues to weaken against foreign currencies, investors lose confidence in the dollar and invest more money in gold.
Inflation involves the loss of purchasing power. When an economy is experiencing inflation, it takes more dollars to buy a product or service than it cost in the past. Investors tend to shift their money to gold when they believe inflation is on the horizon. A greater demand for gold causes the price of gold to increase. Many investors use gold as a hedge against inflation. Fear that the dollar will lose its value causes individuals to invest in a tangible asset that holds value. Many factors can contribute to inflation, such as the printing of additional money to deal with a financial crisis or an increase in costs to manufacture products.
The price of gold and market interest rates are directly related. When the economy is performing well and market interest rates are high, treasury notes, money market accounts and certificates of deposit offer investors attractive interest rates that are greater than the inflation rate. When market interest rates are low, these investments offer low interest rates that are usually lower than the inflation rate. An investment with a rate of return lower than the inflation rate results in a negative return. The low interest rates and negative returns make investing in gold an attractive option for many investors.
Pros and Cons of Investing in Gold
An advantage of investing in gold is that it protects a diversified portfolio from experiencing substantial losses in a volatile economic climate. Investors with a portfolio of diversified assets may experience a decline of certain stocks and bonds and an increase in the price of gold in a struggling economy. A disadvantage of investing in physical gold is that it costs money to store gold. Another disadvantage of investing in gold is that gold prices are affected by speculators involved in day trading, which can make gold prices volatile.
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