Gold and the U.S. Dollar: What's Next?

The question that seems to be the most common among investors lately is what is going to happen with gold and the U.S. dollar? We would like to address this question in a combined context.

Since the spot price for one ounce of gold is normally quoted in U.S. dollars, a further weakening of the U.S. dollar would cause the price of gold to increase, all other things being equal. Maybe that equation is simplified, but essentially for our analysis it’s sufficient.

The U.S. dollar has been trading in a very narrow range against major currencies and the volatility has been decreasing steadily. This is most obvious when one looks at the EUR/USD price graph. The price of EUR/USD has moved back towards the 1.40 level which means the U.S. dollar is weakening again and is now forming a new price floor around current trading levels.

In our view, this is a very negative sign for the U.S. dollar. It shows that when financial markets are performing well, and therefore showing increasing optimism in the outlook for the global economy, the U.S. dollar tends to fall. The correlation on this is actually very high and stable. This highlights the fact that the U.S. dollar is the most liquid currency and used whenever investors seek liquidity temporarily.

However, as financial markets and global economic conditions are expected to normalize (which does not necessarily mean improve), capital is flowing away from the U.S. dollar. This comes on top of the fact that the U.S. economy has significant structural weaknesses and heavy debt burden which will take a long time to improve.

Thirdly, there is also a “chronic” sales pressure which might emerge as global investors and central banks will look to increase their foreign exchange holdings and currency reserves away from the U.S. dollar. Currently, around 62% of global currency reserves are invested in U.S. dollar; we think that number could drop to less than 50% in the coming three years.

Further confusion is caused by statements from politicians and foreign central bankers who have, on many occasions, stated their preference for a strong U.S. dollar. We think these statements are political whitewash and that there is an official version and an unofficial version here. All of these players have significant U.S. dollar reserves which they look to lower in coming months. It’s understandable that they do not want the U.S. dollar to weaken before they had a chance to lower their exposure.

Therefore, our view on the U.S. dollar remains negative and we expect a further devaluation in coming weeks and months. This will of course also have a direct impact on the gold price, which would reflect a weakening U.S. dollar and therefore show a higher U.S. dollar price indication.

We recently discussed the uncertainty of investors not knowing whether deflation or inflation is the more likely risk in coming months. We think that the market’s focus could shift quickly from a deflationary scenario to a discussion about emerging inflation pressures.

In such a case, gold would certainly benefit as it seems an ideal hedge against a weakening U.S. dollar - as well as inflation. Therefore, it makes sense for investors to hold some gold in their portfolio for strategic reasons.

We expect the following for the U.S. dollar and gold:

• U.S. dollar to break out of its current trading pattern and to weaken further
• Increasing selling pressure from strategic investors looking to diversify
• Gold to move towards $1,000 level in coming weeks and months
• Temporary price corrections very likely but long-term uptrend to continue
• Increased demand for gold as a strategic hedge and normalizing trade demand
• Gold to move towards $1,300 level in 2010
• U.S. dollar to move toward 1.50/1.60 versus euro

Comments

[nobby73:]

I agree with your analysis, especially re Euro vs USD, though I think some of the petro-currencies such as NOK will do better.

But, if the increase in gold price is more a function of dollar weakening, wouldn't it make more sense to buy highly rated foreign currency FRNs and at least earn some interest?

Jul 23 07:20 AM

[manya05:]

You paint a very reasonable scenario, if indeed things normalize in the near-term and capital markets start functioning properly, I agree with your conclusions. It is just I am not sure we are done with the big "surprises" just yet.

Jul 23 07:33 AM

[Maxe Paul:]

"U.S. dollar to break out of its current trading pattern and to weaken further
Increasing selling pressure from strategic investors looking to diversify
Gold to move towards $1,000 level in coming weeks and months
Temporary price corrections very likely but long-term uptrend to continue
Increased demand for gold as a strategic hedge and normalizing trade demand
Gold to move towards $1,300 level in 2010
U.S. dollar to move toward 1.50/1.60 versus euro"

Very soon (a month or two) i will be betting against everything you say here, should be a BIG winner IMO.

Jul 23 08:02 AM

[Old Trader:]

Last night, on Bloomberg TV, I heard an Asian fund manager predicting $1.70/Euro in the not too far off future (Q4, if I recall correctly).

Regarding the author's call on gold....far be it from me to argue with a Gnome of Zurich ;-)

Jul 23 08:43 AM

[djj420:]

I'm with you (the author) here, as are at least 2/3 of SA readers/posters. The only thing to worry about is how crowded the trade is, and if enough guys like Maxe Paul can keep shaking out the scared money from the reflation trades. But the shoe will eventually be on the other foot: nobody is going to want to be the last one holding US$ based assets.

Jul 23 09:46 AM

[AndrewBaker:]

Two of the few certainties at present are that the dollar will go down and gold will go up. A rule of thumb is that gold rises as the dollar falls against the Swiss franc, yet at this time gold is going up at the same time as the Swiss franc is falling against US$: Sell dollars and buy gold seems a good strategy right now.

Jul 23 09:59 AM

[Daniel Zurb...:]

Thanks for your comment...I agree, NOK has currently the highest weighting in our model portfolio (19%)..


On Jul 23 07:20 AM nobby73 wrote:

> I agree with your analysis, especially re Euro vs USD, though I think
> some of the petro-currencies such as NOK will do better.
>
> But, if the increase in gold price is more a function of dollar weakening,
> wouldn't it make more sense to buy highly rated foreign currency
> FRNs and at least earn some interest?

Jul 23 10:40 AM

[Daniel Zurb...:]

Gnome of Zurich...not sure, is this now positive or negativ for me...;-)..


On Jul 23 08:43 AM Old Trader wrote:

> Last night, on Bloomberg TV, I heard an Asian fund manager predicting
> $1.70/Euro in the not too far off future (Q4, if I recall correctly).
>
>
> Regarding the author's call on gold....far be it from me to argue
> with a Gnome of Zurich ;-)

Jul 23 10:43 AM

[User 83004:]

What's next? Let us look forward three to five years.

Where is the dollar going to be? The euro is flailing and the dollar is falling. All these fake, fiat currencies are going down.

But I think the US is going to fall soonest, fastest and farthest because we have the most to lose and we've lost it.

Corruption in government, big banks, multinational corporations is the biggest criminal enterprise in the history of the world.

Military adventurism!

Its all become to big to pay for.

And it is failing, flailing and probably falling into some corporate-fascistic-go... enterprise of extraction of the wealth of the middle class of US citizens.

The only answer, at the top (or the bottom, upside down) of the pyramid, is precious metals. Pre 1965 dimes may become a precious means of exchange.

All this fiat currency, backed by only promises redeemable in what? Which country on this planet has a verifiable currency?

How much gold is in Fort Knox?

Real silver and gold in my possession and shares in PM mines seems to me the way to go.

Many thanks and aloha,
David

Jul 23 12:20 PM

[kohalakid:]

A $1.50 or $1.60 euro would kill all business activity in Europe..not like it's bustling now.

I don't see the euro getting that high. I think the dollar will fall against other currencies, but the Europeans are as screwed up as we are.

Why buy their fiat crap???

Jul 23 02:18 PM

[PennySeeds:]

Well, perhaps all the people who converted their life savings to bullion will be dancing in the streets, and yelling "I told you so's!" then.

I'm still divided on whether I see the Euro rising more, or staying put. It could end up being much stronger, but somebody has definitely kneed the poor dollar in the gut.

Jul 23 06:25 PM

[Daniel Zurb...:]

You are probably right...it's all fiat currency, that's today's world...it's a question of relative strenght and weakness, you can compare these currencies and look at them as shares of each nation...it's not that other places do not have problems, but the U.S. Dollar and the U.S. do certainly have the biggest challenges..

thank you for your feedback.


On Jul 23 12:20 PM User 83004 wrote:

> What's next? Let us look forward three to five years.
>
> Where is the dollar going to be? The euro is flailing and the dollar
> is falling. All these fake, fiat currencies are going down.
>
> But I think the US is going to fall soonest, fastest and farthest
> because we have the most to lose and we've lost it.
>
> Corruption in government, big banks, multinational corporations is
> the biggest criminal enterprise in the history of the world.
>
> Military adventurism!
>
> Its all become to big to pay for.
>
> And it is failing, flailing and probably falling into some corporate-fascistic-go...
> enterprise of extraction of the wealth of the middle class of US
> citizens.
>
> The only answer, at the top (or the bottom, upside down) of the pyramid,
> is precious metals. Pre 1965 dimes may become a precious means of
> exchange.
>
> All this fiat currency, backed by only promises redeemable in what?
> Which country on this planet has a verifiable currency?
>
> How much gold is in Fort Knox?
>
> Real silver and gold in my possession and shares in PM mines seems
> to me the way to go.
>
> Many thanks and aloha,
> David

Jul 24 08:39 AM

[uktank:]

things are going such that gold only has to go up. i am going long in it.

Jul 26 12:43 AM

[The Recusant:]

Predicting a drop in the US dollar is a no-brainer. When it will fall over the precipice is much more difficult. As the author says, the foreign reserves will begin to shed the greenback slowly, replacing them with foreign currencies and PMs. But what happens if just one of the big players decides to quickly replace their dollars with gold or the euro or renmimbi? Would this not precipitate a rush to dump the dollar by other countries and banks almost overnight? Pity those faithful allies (think Great Britain here) who get left holding the bag of worthless and devalued dollars.

Jul 26 06:03 PM