Gold And The U.S. Dollar

Includes: FXE, FXY, GLD, UDN, UUP
by: Bob Kirtley

The printing of more paper money usually has the effect of debasing or diluting the strength of that particular currency. The lowering of interest rates also renders a currency less attractive to investors, as better returns might be available elsewhere. The demise of the U.S. dollar can be attributed, in part, to both of the above reasons. However, when this debasement is plotted against other currencies as per the U.S. Dollar Index, we can see that it is having some difficulty when it comes to heading lower, as the chart below depicts.

The reason for this is that the U.S. Dollar Index is made up of a basket of currencies that in themselves are not static and indeed, are involved in various forms of debasement as nations have taken the view that a weaker currency will boost their exports. Japan, for instance, has recently elected a new government whose mandate is to avoid deflation by printing more paper money in order to boost their economy and increase exports via a cheaper yen. As we write, the European Union is meeting to discuss the strength of the euro and the effect that it is having on their ability to export goods. As each nation adopts similar policies, the result could be a kind of gridlock, as every action taken to weaken one's currency is neutralized by a similar action taken by the competing currencies. So we can see that despite Operation Twist and Quantitative Easing, the U.S. dollar is sitting at the "80" level on the Index.

Gold tends to have an inverse relationship with the dollar, and has increased when the value of the dollar has declined. Similarly, as the Japanese yen declined, gold prices reached a record high when purchased with the yen.

So if the actions of our political masters are copied across the board, we could find ourselves in a situation where the dollar trades within a limited range for some time to come, thus capping an advance in gold prices, at least in dollar terms.

One would think that with all this paper money swamping the world, we would experience a huge leap in inflation, which is contrary to what the "official" figures suggest, that inflation is under control.

This leads to us to conclude that, for now, the demise in the dollar is on hold and that inflation is having little effect on the price of gold. I have difficulty believing that inflation will not come roaring back, but for now, we have to deal with what we have. If gold prices are to head north, then it will be because of the fundamentals for gold; supply and demand. Consideration should be given to central bank purchases, the Russian and Chinese imports, the demand for physical gold as opposed to paper gold, various mints running out of products to sell, the reduction in available scrap metal, the ever-increasing difficulties in mining and the lack of new major discoveries. All of which suggests support for gold prices in the longer term, however, the short-term outlook is, as always, subject to volatile oscillations in both directions. With this in mind, we need to proceed gently with our positioning in the precious metals market place, and also be prepared to weather the storm if and when it materializes.

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