Fenil's Library

Human beings are suckers for stories. You, me, everybody. 

We need stories to make a decision and stories to not make a decision as well. If there is no story, we create stories in our mind to justify a decision. So much so, in the rare case that a decision is made without there being a story, we rush to create a story to justify it. 

On the same lines, every bull market has a story going because people won’t invest otherwise. And there is a story behind the bull market in gold. 

So what’s the story behind the price of gold going up? 

To put it in a few lines, the US government owes the world much more than it can ever hope to repay. Depending on which estimate you believe, the figure varies from $50 trillion to $70 trillion. 

Also, the US has been printing dollars big time to tide over the current financial crisis. As the US prints more dollars, the supply of dollars in the market will increase. Experts feel this, over a period of time, will lead to the value of the dollar against other currencies going down. 

Expecting this play out, some international investors have been moving their money out of the US dollar and buying gold; they don’t consider the US dollar a safe haven anymore. And because of this, the price of gold had been shooting up. 

Over a two-year period, gold in dollar terms has given an absolute return of around 35%. Over the last one year, though, investments in gold in dollar terms have made a loss of 3.7%. Around a year back, gold was selling at around $917 an ounce (one troy ounce = 31.1 grams). Currently, it is selling at around $883 an ounce 

The rupee-dollar-gold game 

Though gold hasn’t given any return in dollar terms in the last one year, it has given a return of around 20% in rupee terms. Now how is that possible? 

A year back, gold was selling at $917 an ounce. Back then, one dollar was worth 40 rupees. So to buy one ounce of gold, one would have needed Rs 36,680 (917 x Rs 40). One ounce is equal to around 31.1 grams. So one gram of gold, a year back, would have cost around Rs 1,180 (Rs 36,680/31.1 grams). This means 10 grams of gold (typically the way the price of gold is expressed in India), would have been Rs 11,800.

Now, one year down the line, one dollar is worth 50 rupees. One ounce of gold now costs $883 an ounce. In dollar terms, this would mean a loss of 3.7% vis-à-vis a price of $917 an ounce last year. 

But in rupee terms, the game changes. One ounce of gold would now be worth Rs 44,150 ($883 x 50). This means, 10 grams of gold would cost Rs 14,200, a gain Rs 2,400 (Rs 14,200 – Rs 11,800), or around 20% (Rs 2,400 expressed as a percentage of Rs 11,800). 

Gold is priced in dollars in the international market, like most other commodities. Even though it has given negative returns internationally in the last one year, the Indian investor in gold has made money due to the fact that one dollar is now worth Rs 10 or 25% more in rupees than it was one year back. 

The other currencies 

The entire premise of investing in gold is built on the back of the US dollar collapsing. But over the last few months, it has come to light that other economies of the world and hence their currencies aren’t in great shape either. The British pound, the Japanese yen and the euro have been falling against the dollar, instead of it being the other way around. As the weaknesses of the big economies of the world is getting exposed, money is moving from there into financial securities issued by the US government and hence effectively to the US dollar. This is the primary reason the dollar has held up against other currencies. Also, if the dollar is going to fall, which other currency can replace it? The world still hasn’t come up with an answer to that question.

For an Indian investor, one spoiler could be an appreciating rupee. As mentioned earlier, gold is currently at $883 an ounce, and one dollar is worth 50 rupees. This means, 10 grams of gold currently cost around Rs 14,200. Now let us assume that a year down the line, gold continues to stay at the same price, but the rupee appreciates and one dollar is worth 40 rupees. This would mean 10 grams of gold would cost Rs 11,350, or a loss of 20%. 

For an Indian investor, to make money out of gold, any of the following four things need to happen: 

a) The price of gold in dollar terms goes up; the rupee also depreciates against the dollar. This is the best case scenario. 

b) The price of gold in dollar terms goes up; the rupee continues quoting at the same rate to the dollar as it is right now.

c) The price of gold in dollar terms goes up; the rupee appreciates against the dollar, but it doesn’t appreciate as much so as to knock of the gain in dollar terms.

d) The price of gold in dollar terms falls; the rupee depreciates against the dollar, so as to knock off the fall in price in dollar terms.

If any of these four situations plays out, the Indian investor in gold will make money. But for any of these four situations to happen, a different set of dynamics will be playing out. If forecasting the price of gold is difficult, forecasting which way the foreign exchange markets will head is even more difficult. And you thought investing was simple business.

Conclusion 

The dollar-gold story seems fairly plausible (like most good bull market stories are) right now and chances are it will play out. But in financial markets, as in most other things in life, one can never be sure. 

Bottom line: all investment is but speculation.

Disclosure: The author has investments in a mutual fund, which invests in gold mining companies.