Most people understand that gold is a safe haven asset. Many central banks around the world hoard it. Even our very own central bank – MAS – holds it and regularly reports their holdings.
Yet when there is a crisis, price of gold drops. Shouldn’t everybody be buying gold and driving up its price? To understand this strange phenomenon, let us first note the market’s way of pricing gold.
Markets around the world generally price gold in terms of United States dollars (USD). This means that most of the time, gold is quoted in USD around the world. The dollar is the largest world reserve currency, hence also a safe haven for most traders.
Speaking of traders, traders typically use gold as a last resort fund to cover other losses. Most traders do not trade only one financial asset. They will have a portfolio of assets under their management. As they are taking losses or forced into margin calls for one asset, they will have to liquidate other assets to get funds to cover the shortfalls. This means that as markets start to look dicey, many traders will liquidate their holdings to cover up for their losses.
With enough trading firms facing the same issue, there will be a flood of gold coming to the market and a subsequent shortage of dollars. Hence the drop of gold price against the USD.
You might be thinking, but this doesn’t fundamentally change the fact that gold is still a safe haven asset. And you will be right, however such is the world we are living in, and we would be wise to play the cards we are dealt.
Yet still as the selling continues, the build up of dollars in the hands of market participants means there will soon be a surplus of dollars and a subsequent shortage of gold. This leads to gold’s eventual rise as can be seen after the 2008 Lehman crisis and 2015-2016 stock market sell off.
What we can learn from this is that while gold, just like every other financial asset out there tends to drop during times of financial distress, the silver lining on the cloud is that it presents a good opportunity for us to buy it at a discounted price.
