Gold prices in the first month of 2023 have surged to a seven-month high (see chart). The move in the yellow metal has had several drivers, including lower U.S. interest rates and a sliding U.S. dollar. Concerns have shifted away from high inflation expectations and toward a softening global economy. The market is now concerned about a hard landing where higher interest rates will push growth into negative territory. The idea that central banks could slam on the breaks, remove liquidity to eliminate inflation, and still have moderate growth in the form of a soft landing is fading.

Why Do Gold Prices Move?

Before discussing the surge in gold prices to a seven-month high and the drivers behind this change, it’s helpful to understand why gold prices fluctuate. Gold is a yellow chemical element used as a monetary source throughout history. Gold was used as a currency well before the introduction of paper money. Gold prices fluctuate with supply and demand.

The supply of gold comes from mining. Gold is a mineral that forms in rock formations around volcanic areas. Chemical reactions between hot fluids will create gold particles. According to the World Gold Council, most of the gold is mined in China, followed by Russia and Australia. The supply of gold is generated from mining activities throughout the world.

Several factors drive gold trading demand. Jewelry accounts for approximately 44% of the gold demand. India, China, and the United States are the largest consumers of gold jewelry. About 7.5% of gold demand is attributable to industrial and technology use. Medical devices such as stents are manufactured using gold. Another source of demand is from central and commercial banks. Gold stores wealth and can be exchanged into different fiat currencies. Most Central banks hold paper currency and gold in reserves. According to Bloomberg, global central banks have been purchasing gold since it was abandoned as the reserve currency in 1971. Gold is also used as a source of investment. Gold-backed exchange-traded funds allow investors to buy gold using financial security.

The supply and demand dynamics are simple to follow. When demand is more robust than supply, gold prices will generally rise. When supply overshadows demand, gold prices will typically decline.

What Else Drives the Price of Gold?

As mentioned, gold is considered a store of value. It’s a part commodity and part currency. During economic uncertainty, investors will trade gold because of its long history as a currency. Gold is often considered a safe-haven security for investors that can be relied on during turbulent times. Gold can protect against currency devaluation or political instability. Some also believe that gold can be used as a hedge against rising inflation. As the cost of commodities starts to increase, there are times when gold prices are correlated and grow in tandem with rising inflation expectations.

Gold is also quoted worldwide in U.S. dollars. When the exchange rate of the U.S. dollar rises, the value of gold in dollars also rises. The reverse is also true. When the exchange rate of the dollar declines, the value of gold in dollars decreases.

Generally, when the dollar rises, gold becomes more expensive in currencies other than the U.S. dollar, and sometimes it adjusts lower. When the dollar declines relative to other currencies, gold prices become cheaper in different currencies and sometimes change higher.

What Has Driven Gold to a Seven-Month High?

Now that the supply and demand dynamics and other factors that drive gold have been discussed, the path to understanding the recent surge in gold prices can be explained.

The trough in the gold prices coincided with the peak in the U.S. dollar. As mentioned, as the dollar softens, the price of gold in countries other than the United States experiences a lower gold value. In this case, the dollar adjusted higher to offset the gold value decline. The dollar’s strength has been a function of a changing landscape for inflation.

Why Did the Dollar Decline

The EUR/USD and the dollar index peaked in September 2022 (see charts). The peak in the dollar coincided with the market’s view that the Fed would increase interest rates into 2023 and then stop. According to the CME Fed Tool Watch, U.S. interest rates futures contracts now project that the Federal Reserve will raise interest rates until March through May 2023 and then pause. The markets see the Fed beginning to ease interest rates in November 2022. As policy loosening in H2 2023 has gained market acceptance, traders have sold off the dollar.

Interest Rate Differentials Drive the Dollar Loser

One of the reasons the dollar declined is the positive carry received by owning the dollar over other currencies started to decrease. Carry is a term that describes borrowing at lower interest rates and lending at a higher rate. When you purchase higher-rate money relative to a lower-rate currency, you earn the difference in the interest rates. For example, if one-year interest rates for the U.S. were 4% and the one-year interest rate for Europe was 2%, the owner of dollars would earn 2% per year as the earnings difference accelerates, and the value of owning the dollar over the Euro declines.

The interest rate difference between two countries or regions is the essence of the forward points used to price a transaction. A forward point is equal to 1/10,000^th of a spot rate. The forward points are added or subtracted from the spot rate to create a forward rate. Generally, if you are purchasing a currency pair for a forward date, when you are purchasing a higher-yielding currency, the rate you will transact will be lower than the current spot rate.

When the forward rate for owning the dollar started to decline, and the discount investors received began to fall, the momentum created dollar index selling.

Why Did Interest Rates Start to Decline

There has been a noticeable stabilization of consumer inflation. According to the Labor Department, U.S. December CPI slowed for the 6^th consecutive month. The core level of CPI, which excludes food and energy, increased by 5.7%, declining from 6%.

Wholesale Prices Declined

The wholesale side of the equation usually feeds into consumer prices, so continued declines. According to the U.S. Labor Department, produce prices declined by 0.5% month over month, which was a more significant drop than expected. PPI increased by 6.2% for the year

, which is the lowest yearly level since March 2021. Energy prices were the catalysts for the decline. Core PPI, which excludes food and energy, increased by 0.1% month over month.

Retail Sales Dropped

Holiday sales in the United States fell short of forecasts. Higher interest rates and inflation kept many consumers on the sidelines. Sales rose 5% compared to the 6-8% expected. The decline in holiday sales damaged overall retail sales in the United States. According to the U.S. Commerce Department, U.S. Retail declined in December, dropping by 1.1%.

Seasonality Impacts Gold Prices

Gold prices generally rise in January. The GLD SPDR Pro Shares typically increased in January (see chart). During the last 19 years, Gold prices have been up about two-thirds of the time for an average gain of 3.2%.

The Bottom Line

The Upshot is that there is a pathway that can be described why gold prices have increased to 7-month highs in January. The main ingredient has been a weaker U.S. dollar. As mentioned, the dollar started to soften as the acceleration in U.S. interest rates relative to other countries started to decelerate. The Federal Reserve in the United States raised rates from zero to 4.25% in 2022. The increase was sharp, which helped buoy the dollar to new highs.

As the markets started to see a concern over growth and less over inflation, U.S. interest rates began to slide. The decline in U.S. rates related to trading partners led to a change in the interest rate differential which reduced the benefit currency traders received from the forward curve. Holding on to dollars relative to the Euro and other currencies became less beneficial. Since gold is mostly quoted in U.S. dollars, the drop in the dollar allowed gold prices to accelerate higher.

Additionally, there is some seasonality at play. Gold prices also generally rise in January, which has helped lead to a rally to a seven-month high. The question for traders is whether the Fed is done raising short-term interest rates. If they need to continue to push rates higher, gold prices will be capped. If they reverse course, there is further upside for the gold prices.