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Why Increased Demand For Physical Gold Can Cause Short-Term Spot Prices to Drop

CryptoNotBlockchain Editorial

February 7, 2025

The gold market can sometimes behaves in ways that defy traditional expectations of supply and demand. One of the most perplexing phenomena is that increased buying of physical gold—a sign of strong demand—can sometimes cause the spot price of gold to fall. This counterintuitive outcome arises from the structural differences between the physical gold market and the paper gold market, as well as the mechanisms that dominate price discovery.

In this article, we’ll unpack how these dynamics work, why they occur, and what they mean for gold investors.

Physical Gold vs. Paper Gold: The Key Distinction

To understand why buying more physical gold could lead to a drop in spot prices, it’s essential to recognize how the gold market is structured:

Physical Gold: This refers to tangible gold, such as bars and coins, purchased by individuals, central banks, or institutions. Physical gold is limited in supply, costly to store, and commands a premium over the spot price due to logistical and storage expenses.
Paper Gold: These are financial instruments that track the price of gold, such as futures contracts, ETFs (e.g., SPDR Gold Shares), and unallocated gold accounts. Paper gold dominates the market in terms of trading volume and liquidity, making it the primary driver of the spot price (the global reference price for gold).

Key Point: The spot price is primarily determined by the paper gold market, which often behaves independently of physical gold supply and demand.

How Buying Physical Gold Can Lower the Spot Price

At first glance, it seems logical that increased physical gold buying would push prices higher. After all, strong demand should tighten supply and raise the price. However, in the current gold market structure, the opposite can happen under specific conditions.

1. Physical Gold Demand Rises

When investors seek physical gold during periods of economic uncertainty, geopolitical crises, or inflationary fears, several things occur:

Physical gold premiums (the cost over the spot price) increase due to limited supply and logistical constraints.
Retail and institutional buyers compete for available gold, further driving up premiums.

This reflects genuine demand in the physical market—but it doesn’t always translate into rising spot prices.

2. Paper Gold Holders Respond to Physical Market Signals

The rising premiums for physical gold can signal to paper gold holders that:

The physical gold market is under strain.
There may not be enough physical gold to meet delivery demands for futures contracts or unallocated accounts.
A systemic risk could emerge if confidence in the paper gold market erodes.

Instead of buying more paper gold contracts, these holders might panic sell their positions, fearing a potential liquidity crisis or default in the paper market.

3. Paper Gold Selling Drives Down Spot Prices

As paper gold dominates price discovery, selling pressure in this market can drive the spot price lower:

Futures contracts are highly leveraged, so even small selling volumes can have an outsized impact on prices.
ETFs may experience outflows, requiring the sale of futures contracts, amplifying the downward pressure.

Result: Even as physical gold premiums rise, the spot price (set by paper gold trading) may fall.

4. Spot Price Decline Reduces Physical Premiums

The paradoxical decline in spot prices helps stabilize the market:

As the spot price falls, the total cost of physical gold (spot price + premium) becomes less prohibitive.
This reduces the urgency among buyers to acquire physical gold, alleviating pressure on the physical market and calming fears of a shortage.

Why This Happens: The Self-Correcting Mechanism

This counterintuitive dynamic serves as a stabilizing mechanism for the gold market, preventing runaway price increases. Here’s how it works:

Spot Price Reduction Discourages Panic: Falling spot prices reassure the market that physical gold shortages are manageable, reducing the risk of systemic panic.
Liquidity Needs in Paper Markets: During financial crises, investors often liquidate liquid assets like ETFs or futures to raise cash. This selling pressure further drives down the spot price.
Most Paper Contracts Don’t Require Delivery: The paper gold market operates on the assumption that most participants will settle contracts in cash, not physical gold. This reduces the immediate strain on physical supplies.

When Would a Physical Gold Shortage Push Prices Higher?

In the long term, sustained physical demand or systemic distrust in the paper gold market could force prices higher across both markets. Here’s when this could happen:

Sustained Physical Delivery Requests: If a significant number of paper gold holders demand physical delivery rather than cash settlement, the limited physical supply could create a delivery squeeze, driving up spot prices.
Erosion of Confidence in Paper Gold: If investors lose faith in the paper gold market’s ability to meet claims, they may shift to physical gold, aligning the spot price with physical demand.
Central Bank or Institutional Buying: Large-scale purchases by central banks or major institutions can tighten physical supply and lift both physical and paper gold prices.

Historical Example: March 2020

The COVID-19 pandemic in March 2020 provides a clear example of this paradox:

Physical Gold Demand Soared: Investors sought safety in physical gold, leading to shortages and skyrocketing premiums. BullionStar reported unprecedented demand from retail and institutional buyers.
Spot Price Fell: In contrast, the spot price declined as investors sold paper gold to raise cash during the broader market sell-off. On March 13, 2020, gold prices fell 4.6% in a single day, despite strong physical demand.

Conclusion

While it might seem logical that a run on physical gold would push prices higher, the reality is more complex. Increased demand for physical gold can sometimes lead to a short-term decline in spot prices as paper gold holders react to physical market signals with panic selling. However, if physical shortages persist or confidence in paper markets erodes, both physical and spot prices can then rise sharply.

The interplay between these markets highlights the importance of understanding the unique structure of the gold market. Whether you invest in physical or paper gold, being aware of these dynamics is key to making informed decisions in times of economic uncertainty.