Gold and oilWhat moves 2 of the world’s most watched markets.
Gold and oil both react to the US dollar and the money supply. Gold also reacts to fear, oil to growth, war and supply. Their big swings between 2002 and 2016 show each driver at work.
Gold in a world of fiat money
Until the early 1970s, money was tied to gold. A central bank had to hold a fixed amount of gold for the money it issued, and since gold reserves cannot simply be enlarged, it could not print money at will. That system is gone. Today all currencies are fiat money: money with no value of its own, backed only by trust, which central banks can expand whenever they decide to.
That is where gold comes in. When central banks print money and keep rates low, paper money loses appeal and gold, which nobody can print, gains. When rate hikes come into view and confidence in the dollar returns, gold loses that appeal, partly because it pays no interest. Fear works in gold’s favour too: in a market scare such as the Brexit vote, money looks for a safe place to sit.
So when gold rallies, check what is behind it. A rally on a weaker dollar and talk of rate cuts has the money supply behind it. A rally driven only by fear depends on the fear lasting.
Gold from 2002 to 2015
Gold’s long rise shows these forces one after another. The US dollar reached a multi-year high in early 2002 and then fell for about 6 years, weighed down by the Iraq war, a sluggish US economy and falling stock markets. With the dollar weaker, commodity prices rose strongly across the board, gold among them.
In 2008 the Fed started quantitative easing, and it kept buying bonds until the end of 2014. Its balance sheet grew fast and the gold price climbed with it, up to an all-time high in 2011. Then the picture changed. The US economy recovered better than expected, rate hikes came into view, the dollar strengthened until late 2015 and gold fell back.
6 weaker years lift commodities
Its balance sheet and gold rise together
An all-time high
The US recovers, hikes come into view
Confidence in the dollar is back
Oil: energy and inflation
Oil is the most widely used energy source in the world, covering about a third of global energy consumption. Many grades are traded, but 2 serve as the reference prices: Brent for Europe, and WTI, also called light sweet crude, for the US.
Oil feeds straight into inflation. It carries 23% of the weight in a widely followed commodity index, far more than any other commodity, and that index moves almost in line with eurozone inflation. Europe is one of the world’s biggest oil importers, so a big rise in oil lifts its inflation sharply and can change what the ECB does. The US imports less oil in proportion, so the effect on its inflation is weaker.
What moves the oil price
Oil rises when there is war, when the dollar weakens and when growth pushes demand above supply. It falls when the dollar strengthens, when there is too much supply for the same demand and when a recession cuts demand.
The years after 2002 show all of these. The Iraq war and a weaker dollar drove oil up until mid-2008, and the surge lifted eurozone inflation so far that the ECB raised rates to counter it. Then the dollar strengthened and the financial crisis crushed demand: in half a year, oil fell from over $140 a barrel to about $40.
In early 2009 the US launched a stimulus package and kept rates low, the dollar weakened again and oil recovered until mid-2014. From there, a stronger dollar and an oversupply from the fracking boom in the US and Canada pushed it down until early 2016.
| Asset | Rises when | Falls when |
|---|---|---|
| Gold | The dollar weakens, money is printed, fear hits markets | The dollar strengthens and confidence returns |
| Oil | War, a weaker dollar, demand above supply | A stronger dollar, too much supply, a recession |
In short
- All currencies today are fiat money, so gold tends to rise when the dollar weakens, money is printed or fear grips markets, and to fall when the dollar and confidence return.
- Oil rises on war, a weaker dollar and strong demand, and falls on a stronger dollar, oversupply or a recession, as in 2008, when it dropped from over $140 to about $40 in half a year.
- Oil feeds straight into inflation, above all in Europe, so a big move in oil can change what the central bank does.
Key terms
- Fiat money
- Money that has value because a government declares it, not because it is backed by gold. All major currencies today are fiat money.
- Quantitative easing (QE)
- A central bank creates new money to buy bonds. It pushes yields down and adds money to the system, which usually weakens the currency.
- Brent and WTI
- The two benchmark oil prices. Brent is the European benchmark, WTI (West Texas Intermediate) the US one.
- Money supply
- The total amount of money in an economy. More money chasing the same goods tends to push prices up.
- Inflation
- The rate at which prices rise. Central banks usually aim for about 2% a year.
- Recession
- A period in which the economy shrinks instead of growing, usually with rising unemployment.