The main reason for the abnormal rally in the gold prices since March 2020 was that long-term investors were looking for risk diversification and started pouring money in gold ETFs and Sovereign Gold Bonds.

Recently gold prices have witnessed huge volatility. Globally, gold prices have risen by over 25% in the first seven months of 2020. In rupee terms, the yellow metal has seen a 40% rise in India during the same period. Gold has outperformed all other major asset classes during this period. Interestingly, during this unprecedented rally of gold prices, the two major traditional consumers of gold, India and China, remained on the sidelines.

Nevertheless, the dream run for gold ended in the last few days. Globally gold price fell by almost 4.5% in one of the recent weeks (Chart). On the Multi Commodity Exchange of India Limited (MCX), October (2020) gold futures fell by 5% during the same period. Such huge two-way swings in gold prices raise a number of important questions. Why did price of the yellow metal rise so much in the midst of the Covid-19 pandemic? What are the possible reasons for the recent fall? Finally, if the major consumers of gold were not buying, who were the alternative buyers?

Conceptually, demand for gold can have two distinct sub-components. First, gold demand is linked to demand for ornaments and Asian countries in general and India and China in particular may be the major sources here. Second, apart from this consumer demand for gold, there is an investment demand for gold. Historically, gold was used as a protection against inflation and as a hedge against currency volatility. Precious metals, like gold, thus, also behave like a currency whose attractiveness depends on the strength of the dollar. Such precious metals may be perceived as a distinct and an attractive asset class in times of financial crisis. From this viewpoint, consider the trends in two major competing assets class, bond and equity.

First, with the Covid-19 crisis imposing severe economic cost, and the central banks of most of the developed countries started following an accommodative monetary policy, interest rates world-over nosedived. A Bloomberg report of July 2020 revealed that the global pile of debt with negative yield have reached almost $15 trillion mark. The bond yield is expected to remain subdued at least for next one year.

Second, the global equity market was also not doing any great when the Covid-19 pandemic started surfacing all over the world. For example, in March 2020, the S&P 500 index in the US sank the most since the 2008 global financial crisis.

Thus, sophisticated investors and fund managers have realised during the pandemic that the traditional asset classes (debt and equity) were too risky to stay put and looked for safer investment to hedge against equity volatility. Since gold is considered as a safe haven during an economic crisis, it is no wonder that the world witnessed significant fund flows in gold.

Are the happy days for gold over? If gold was having such a dream run till July 2020, why did it fall recently? Three possible reasons could be cited, viz., (a) armed by the huge liquidity injections of major central banks, global equity market has rebounded since March 2020; (b) strengthening of the US dollar; and (c) profit booking by gold funds. Perhaps not so surprisingly, when Russia recently announced successful launch of Corona virus vaccine, markets could have sensed some light at the end of a long dark Covid tunnel, and hence the world witnessed a sharp downturn movement in gold price. This downturn could have also been fuelled by multiple pharmaceutical companies making claims of market-ready vaccine in another six months.Thus, investors could have started booking profits (from gold) and investing in equity markets. Paradoxically, in Indian case, when gold prices reached an all-time high of Rs. 56,000 in early August 2020 and the RBI raised the loan-to-value limit for non-agriculture gold loan to 90% (from 75%), the gold prices fell by more than 10% after the announcement.

Who are buying gold? The main reason for the abnormal rally in the gold prices since March 2020 was that long-term investors were looking for risk diversification and started pouring money in gold Exchange Traded Funds (ETFs) and Sovereign gold bonds. Until July 2020, global net inflows to gold ETFs touched $40 billion. Traditional buyers of gold, retail investors and jewelry buyers do not have money at this moment to buy gold. It is the pension funds, insurance companies, and managers of ultra-high net worth individual funds who are taking great interest in gold.

The hero of Satyajit Ray’s movie, ParashPathar (Philosopher’s stone) found a stone that could touch any metal and turn it into gold. But as history has shown us, the world is yet to find that kind of a stone and any unusual glitter of gold typically did not seem to last forever.

(By Ashok Banerjee and Partha Ray, Professors at IIM Calcutta)

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