June was the weakest month since the end of 2016 so far, and the potential investment in gold seemed like the wrong move to many. In June, the precious metal fell 7.6% and the London Bullion Market Association (LBMA) fell 7.1%. As a result, in the first half of 2021 the price of gold fell by 6.6%. We have seen this drop across almost all currencies except the Japanese yen and the Turkish lira.
However, exchange-traded funds (ETFs) have acted like never before – amid falling prices, they have increased their gold holdings. In this article, we’ll look at the dynamics that have led to fluctuations in its value, the history of exchange-traded funds, and the importance of their growing investment in gold.
The reason for the decline in the price of gold was related to the forecast that the major global economies are returning to growth and that inflation is starting to fall. In mid-June, the dollar was relatively stable against other currencies, and the dollar index rose to its highest level since late March.
Last but not least, there was a slight increase in interest rates on US government bonds in June. However, it was an extremely small and short-lived increase. Subsequently, their profitability fell to the level of the end of February. US government interest rates are an important guide to gold price changes and are good to keep in mind when monitoring gold price swings.
Thus, the reasons that led to the sharp drop in the price of gold in June are no longer observed in the markets.
Currently, we are witnessing a different situation. The European Central Bank has changed its inflation target so that it can increase money printing almost indefinitely. This will undermine the purchasing power of the euro.
In the United States, the overall picture is not very encouraging. In May (data for June was not available at the time of writing), the US dollar saw its fastest depreciation since 2008. A growing number of analysts expect inflation to remain high over the next few years. Bank of America recently joined this view, in opposition to the position of Federal Reserve Chairman Jerome Powell, who argues that the weakening of the dollar’s purchasing power is a “transitional” phenomenon.
Before discussing gold as an institutional investment, it’s good to have an overview. When the price of gold rises, exchange-traded funds increase their buying volume. Instead, as the price falls, they reduce their gold reserves.
This behavior makes complete sense given the way exchange-traded funds operate. ETFs hold a certain amount of physical gold against the shares they issue. In this alternative gold investment channel, investors do not buy the metal, but exchange-traded fund shares, which are a “reflection” of its price.
The relationship between the price of gold and ETF investments is always the same, usually with an extremely small gap. In June, however, an almost unprecedented phenomenon occurred: Although the price of gold fell sharply, exchange-traded funds not only did not reduce their net reserves, they increased them. Net ETFs sold 23.7 tonnes and bought 26.6 tonnes of gold. Thus, their gold reserves increased by almost 3 tons globally.
Data from the World Gold Council show that the slight decline in Europe (-0.6% from May) was fully offset by North America (+0.6%) and Asia (+1.7%). Thus, at the end of June, funds traded on the stock exchange held 3.6 thousand tons of gold.
Although today their gold holdings are below the all-time high of last summer and fall, since the financial crisis of 2008, the ETF’s holdings have increased by an impressive 230%.
The dynamics we have witnessed are so strange that they require explanation. There are at least 2 reasons for the behavior of exchange traded funds:
- A short-term drop in the price of gold is expected
If a category of institutions has always sold gold when its price was falling, but suddenly stops doing so, with the most dramatic decline in recent years, it is clear that the decline is not expected to last long. In hindsight, we know that’s exactly what happened. A month apart, the price of gold rose again and crossed the psychological limit of $1,800 per ounce;
- ETFs continue to see gold as a good investment despite its falling price
The sharp decline of more than 7% in just one month might seem like a “total collapse” for gold. It’s not necessary. The precious metal continues to be seen as a savior of purchasing power.
This is true not only for exchange-traded funds, but also for central banks, the other major category of institutional investors in gold. In June, central banks around the world continued to buy gold. The actions of financial institutions and ETFs clearly show that investing in this precious metal is safe and profitable.
There is no other way when the fundamental behind the price of gold remains stable. The solidity is due to the actions of central bankers, who send inflation to unprecedented levels and suppress interest rates. As they have no prospect of changing any time soon, the price of gold will receive guaranteed support.