Gold owners are pleased to see the bounce in the precious metal this morning. It is up to $1,688 a troy ounce as I write this.
Some are puzzled as to why its price plunged from just over $1,900 to just under $1,600 in a matter of a few weeks during the recent stock market selloff.
The answer is an exercise in the interconnectedness of the financial world.
Most people do not sit with their assets in their basement. Also, even after a 10-year gold uptrend, most people own mostly paper assets.
These assets fluctuate in price just like gold does.
Imagine if you are an international hedge fund. Your clients are from the United States. They give you dollars. You borrow additional dollars from banks to leverage up to buy assets.
Your eye lights upon Europe’s eurozone as a better bet than U.S, assets. You want to buy European stocks. You must sell the dollars to buy euros, the currency of the 17-nation eurozone.
You sell your dollars, which puts downward pressure on the value of the dollar. You buy euros, putting upward pressure on its value.
In normal times, you need a microscope to see the impact on exchange rates.
As a prudent hedge fund, you also buy gold. Gold is priced in dollars, but you still must pay a small commission, the size and nature of which depends on whether you are buying physical metal or exchange traded funds, or various other forms.
You are sitting pretty until the Greek crises hits. Suddenly Europe doesn’t look like a good place to be invested.
You sell your European securities. In a crisis atmosphere, many others are doing the same thing. Prices slide. You take losses.
You now have euros, but your American bankers are nervous that you are overexposed. They want to rein you in and lower their risk by demanding all or part of their dollars back.
You have to buy dollars with your euros to repay your loans. This pushes the dollar price up and the euro down amplified by all of the other financial entities doing the same thing.
You are taking a big hit. Your investors get nervous. They start asking to get their money back.
You have gold. You have a nice profit in it. You would like to hold on because it has been good to you, but you have losses from the sale of other assets and you have investors wanting their money.
So you sell gold. Many others have to do the same thing. This pushes the metal down.
Was it smart to sell the gold?
In this case, you have to define smart as surviving in business. It is better to meet all of your financial obligations when they are presented to you. That means you are still solvent and you get to stay in business and try again.
Gold’s price is not simply about the metal. It is also about the needs of its owners, too.
When the crisis passes, the hedge fund gets to try again, buying the assets it prefers to own. What will it choose this time?
Today, at least, there are 1,688 reasons that it might just be gold.