Dollar-Gold Relationship Inspires 'New Economic Theories'

For some time now, the changing relationship between the U.S. dollar and gold has been noted in my articles and now others are talking about it, too. The latest commentary can be found in this Wall Street Journal report($) by David Gaffen and Joanna Slater.

Dollar and Gold Are Suddenly Inseparable
The dollar and gold are no longer ships passing in the night.

For the better part of this decade, the price of gold and the value of the U.S. dollar tended to move reliably in opposite directions -- when gold went up, the dollar went down, and vice-versa. The reasoning is that a weaker dollar can feed into worries about inflation. That in turn prompts investors to turn to gold, a hard asset in limited supply whose value typically rises in inflationary times.

Lately, though, gold and the dollar have been rising in tandem as frantic investors seek safety from contracting world economies, teetering banks and radical governments stimulus plans.

Is that what it was?

While there is no doubt that the two have been rising together lately, the explanation of their divergent journeys earlier in this decade rings a bit hollow, as do most other explanations for the inverse relationship between the dollar and gold.

For example, the gold price has risen for the last nine years, whereas, the U.S. dollar has lost ground to other paper money around the world during seven of those years.

That says a lot more about gold than it says about the dollar-gold relationship.

Moreover, there seems to be only a casual relationship between the trade weighted dollar and inflation. For example, the U.S. Dollar Index fell during all of 2006 and 2007, a time when official measures of inflation were, in fact, receding.

If a falling dollar sparked fears of inflation, those fears were unfounded, however, those investors opting to buy gold on this misplaced fear were better off as a result.

I've always thought that twitchy traders, conditioned like Pavlov's dogs to sell the dollar when gold rose and to buy gold when the dollar tanked, was the the sum and substance of the explanation of the relationship between the two.

Surely some experts have an explanation...

The recent coupling "goes against the economic theory, so now you have a lot of new economic theory," said Richard Bernstein, chief investment strategist at Banc of America Securities Merrill Lynch research.

Hans Olsen, chief investment officer at J.P. Morgan's private wealth management unit, said investors shouldn't cling to expectations that the dollar and gold will fall back into old habits. "There is not some immutable axiomatic inverse relationship" between the dollar and gold, Mr. Olsen said. "There are periods of time where the market might assign a linkage, and there are times when the different assets trade differently for different reasons."

Some investors say the reason the old inverse relationship isn't working is because gold is no longer simply an anti-dollar bet, but a wager against currencies more generally. In other words, gold isn't just a hedge against a weaker dollar, but a form of protection against the temptation for any government to devalue its currency.

"The gold price is up in any currency, really," said Alan Ruskin, chief international strategist at RBS Greenwich Capital. "What that's telling you is that we have perceived problems lying ahead for paper currencies."

Mr. Bernstein's "new economic theory" theory notwithstanding, it seems that it's a lot easier to explain the recent coupling than the historical relationship.

On that matter, Mr. Ruskin seems to have hit the nail squarely on the head - all paper money is looking shaky at the moment against the yellow metal.

Here's an update of the two as of yesterday- they are settling into a perfect non-correlation, as should be the case since there really isn't a fundamental relationship between the two.

Comments

[Adam Hayes:]

dont forget silver! It, too, has rebounded against all currencies and I see more % potential in silver than in gold.
Interestingly scarce metals (platinum, palladium) have recovered some (2005-06 levels) after collapsing from all time highs.

I agree with the author and my feeling is that as world gov'ts continue to print money to stimulat ethe economies that precious metals (and other hard commodities) will see a price increase against all major currencies.

Mar 17 09:27 AM

[Vuke:]

Gold has been gradually rising against all currencies in the last few years. Fluctuations in the dollar are usually compiled against other currencies somewhat obscuring this trend.

Lately however, the rush to a safe haven has lifted both the dollar and gold (vs. foreign currencies) creating an interesting scenario. What happens if the dollar begins to decline against gold?

Given the massive stimulus dollar packages being distributed world-wide it appears likely we will soon see an answer to this question. And, given the amount of currency circulating it's unlikely we'll see gold decline.

Mar 17 09:57 AM

[SW Richmond:]

"all paper money is looking shaky at the moment against the yellow metal."

We have not yet achieved capitulation in the financial markets. The evidence is all around us, most recently the strength in Treasuries and Gilts when the Fed and BoE announced either willingness to monetize, or actual monetization of national debt. This can only mean one thing: the bulk of investors still believe in the long-term health of the status quo financial system and the power of the central banks, still believe that the current crisis can be solved by intervention.

Think about it: The world's largest economy, and their longest-running financial and political ally, announce their outright willingness or intention to literally print their way out of financial difficulty AND THE HOST GOVERNMENT SECURITIES MARKETS REACT POSITIVELY TO THE NEWS. In my view there is no other way this can be interpreted than rampant bullish (positive) expectations.

We are in the early stages of what is obviously a generational event. We cannot achieve a genuine bottom until this significant residual bullish sentiment is expunged. And, IMO, expunged it shall be at some time, by a significant event in Gilt and Treasury markets. How can printing a currency be good for it? Simple math disallows such lunacy.

The Yen may be starting to crack. USD is the last man standing. When USD falls there is only one place left to hide, and the hiding place is very very small market.

Mar 17 10:27 AM

[Conan the B...:]

Your statement says it all: "For example, the US Dollar Index fell during all of 2006 and 2007, at time when official measures of inflation were, in fact, receding."

"Official" measures meant the exclusion of the necessities of life, Food and Energy. The dollar fell in reaction to rapidly rising Real Inflation.

The Dollar's rise started a few months after Oil's peak and increased in value rapidly because of The Russian Invasion of Georgia and then the Financial Crisis and the Really bad case of Risk Aversion.

At first, Risk Aversion strengthened the USD against almost all comers, but thereafter, when the scope of Future USD printing started getting some real focus, Gold started to rise with it.

At some point, Risk aversion will mitigate, the USD will drop and Gold will rise in anticipation of future inflation.

I do not know when but have a "gut" feeling it will be soon. The Rise in the Dogs of the Financial Sector are a sign that things will not appreciably worse.

IMHO

Mar 17 11:10 AM

[sdavid0419:]

Whats taking so long for the guy driving a cab to be telling you he just bought gold? A previous poster said you'd know it was too late to get into gold once the cab driver was getting in. The answer is the cab driver ie. the man on the street hasn't got anything left to buy gold with after his 401k and ira's took huge losses that were tough to avoid due to penalties for early withdraw and restrictions on some of those investments movement of assets. I shudder every time one of my friends confesses their losses to me since I warned them off the market do to the obvious housing bubble and they agreed with me but didn't act? Not only is the government printing money to get work years in advance of when they will have the ability to pay for it they are paying off crooked bankers hundreds of millions of dollars for complete disregard for the law and driving the worlds largest insuarnce company into the ground. To all the hot air that rose out of Washington yesterday that said if I did what you did I'd be fired....I say you did do it by paying them and you should be fired. Cases in point Rep Barney, Rep Blount, I'd include President Obama in the fire them now category except the actual money paid out this time came from the Bush giveaway. I am so sick of this worthless rhetoric that comes out of Washington. My own Senators McKulski and Cardin answered my letters begging them not to use my taxpayer money to bail out the AIG crooks assured me they would not vote for it unless it contained protection for the taxpayers against giveaways to the crooks yet both of them voted to do so. I think the solution to all of our problems is to start holding our elected officials criminally responsible for their actions and in the mean time I'll take my change in GOLD thank you.

Mar 17 11:14 AM

[@TexasER:]

The gold market is the size of an Ant, compared with the elephant sized USD market. Because of that, gold will move wildly on countless micro-factors that only a full-time analyst has a prayer of understanding.

I'm not saying you can't occasionally find significance in the correlation, but I wouldn't trade on it.

Mar 17 12:14 PM

[Alex Filonov:]

1. One month is not enough to change economic theory.
2. There is a lot of hot money on the market right now, jumping from one market to another. It's no use to invent theory to explain every possible jump.

Mar 17 01:05 PM

[Conan the B...:]

I liken it to the links in a chain fence, you can picture what the fence will eventually look like. But currently those links are lying on the ground.

The final picture is available, all you have to do is figure out what goes where.

:) :)

Mar 17 01:14 PM

[Bones:]

The dollar is up because relative to other countries we are the best of the worst options. Also, look around, the price of everything is cheaper, so the dollar is clearly stronger. That said gold has moved up even in dollars but it's moved more in foreign currencies than in dollars which says it's moving for various factors. Part of it is fear, part of it is expected inflation from government spend. What I doubt we have is real increased demand. So right now it's a fear/inflation expectation play. Incrementally fear has subsided and gold has sold off. Inflation remains the longer term driver but it's unclear that will happen although it makes sense. Keep in mind that although the government is printing money like never before, all of that is an attempt to reinflate. They are trying to fill a hole from the wealth evaporation in housing and that appears to be a futile attempt. So we may not see the inflation that everyone is expecting. For most people, their house is their largest asset, if that house now costs $300k instead of $500k where did that money go? It evaporated. Value is based on perception. Perception has changed dramatically and people are not going to pay what they used to because $'s have become SCARCE! Do you know anyone buying yachts these days??? Therefore, when something is scarce and in high demand the value of that something goes up. That something is $'s.

Mar 18 10:02 AM

[Conan the B...:]

Bones: just a few months ago, a casino I frequent in Illinois was virtually empty during times when it used to be very crowded.

The crowds have returned, not to previous levels, but enough to notice.

Here, in the USA, dollars were scarce because of FEAR, as fear recedes, so will tight fingers.

Outside of the USA? Dollars are definitely not "scarce".

Mar 18 11:41 AM

[Eric in IL:]

I think you guys need to guard against a Gold Bias here. Gold is trading at $1100+ in March 2008 dollars. It looks to be breaking down through its trendline today. The relationship between gold and the dollar is completely linked, but like all things has become completely distorted in this market environment. It will go back to normal, but Gold will fall back before the dollar does. The dollar has incentive to go stronger before other currencies, we have no more rates to cut, our economy should pull up before others, our interest rates should rise before others as we come out. Money Supply is not expanding like everyone thinks. Bullish Gold here is an early trade against the dollar, and over the next 3 months is gonna be a losing bet. I'll buy gold when it comes back in.
Long GLL

Mar 18 01:12 PM

[occdude:]

It makes perfect sense how the dollar and gold have been like long, lost buddies (except for today).

Deflation was all the rage, BUT there are hints that massive infllation is in the works. This would lead to one buying both as a hedge. The line of reasoning would go like this "deflation is definitely kicking behind but, Bernanke keeps talking about qualitative easing and literally printing money. What should I do?" . That being said how would you react? Maybe just a wee bit confused??

It's heartning to see however, that an inflationary cycle is kicking in as of TODAY with fed starting to monetize. The normal relationship between gold and the dollar where one goes up or down against the other is being re-established.

It's also interesting to see the transfer of momentum between inflation and deflation manifesting as a coupling between the dollar and gold for a short period as one force seeks to dominate the other.

As of today and for probably the next 6mos. inflation is going to rule. Look for higher prices, equities, commodities, retail prices and maybe even real estate, but especially gold.

Mar 18 09:21 PM

[Hitz:]

What does everybody feel about gold and dollar relationship after yesterday's move? Is this relation back to the old times or will we see divergence again of gold and $ relationship?

Mar 19 01:26 AM

[Conan the B...:]

User 29: Personally, I believe the norm will return, with an added twist:

USD down, GOLD up = inflation
USD up, Gold up = general Fear.

Mar 22 02:23 PM

[svosavvy:]

Jack, I mean texas Er, gold is the "end of the world" trade which is now the size of an 800 lb ant, why not look to the silver as a more indicative mean? There is a lot of uneducated money piling into gold at the behest of assanine money managers the same ones who said buy real estate home builders in 2007. The cholera well continues. I would offer that the gold trade has become a macro theme that is subject to the vicissitudes of the faithless who are zombies at the beckon will of their cfp's. Honestly, gold bugs are pushing a macro trend that says the dollar is dead and everyone will lose faith, doomsday is here and we will be using gold for everything from haircuts to oil changes (I can't blame them since gold hasn't been a smoking investment since 1981). So how about this, without a good assayer, we will be buying our steak dinner with gold dust. If you like the rampant inflation idea how about a little silver, honestly if the dollar becomes illiquid and we have to use hard currency I think the silver bits will be a little better positioned for daily use. I find the gold a tad unoriginal, basically, if you believe in inflation as I and everyone else do anything that isn't a dollar should rise in the face of the dollar. Don't limit yourself to gold, the renminbi and canadian dollar could be strong currency plays, silver or commodities in general could be good plays or TIPS. I like US stocks, the weak dollar will be kind to them, get a good dividend player that imho is the best.

Mar 23 12:44 AM