When Central Banks Buy, Gold Surges

The last few years have had a common currency denominator, in the demise of the dollar, with the financial markets moving away from the dollar since March 2009.

The dollar sell-off since March coincided with every major asset class moving higher in price, including equities and commodities, and as an anomaly, higher interest rates. This was good news for retail and institutional investors, but on the other side of these trades were the central bank’s reserve, and sovereign wealth funds which were hit by the dollar’s falling value.

Financial theory says that investors should always diversify their risk across a range of different instruments. However, this did not really happened for central banks, since almost 2/3 of all reserves are denominated in U.S. dollars. This means that every move that the dollar makes is directly reflected on the CB’s balance sheets, by reducing the assets value.

If the dollar had a stable value, this would be fine, but since 2000 the Dollar Index has travelled a roller coaster ride, that finished 120 ticks lower, to today’s close of 75.00. That is an approximate loss of 37%, which means that central banks have lost a huge amount of power to defend their exchange rate, and by default have seen a rising local currency. For a major central bank this is not a vital problem, but for a smaller one, losing its ability to influence the market is dangerous.

In order to counter this trend, central banks can in general only diversify from the dollar either by buying gold. This is the only commodity that can be stored without significant depreciation in the long-term and priced in dollars– or buying the relatively newly formed euro currency, which still has to prove itself as a global alternative, and still has to pass some structural reforms.

The dollar’s depreciation and central bank’s attempt to diversify from it has helped gold become the best yielding asset of the last few years of trading. Since 2000, the SPDR Gold Trust ETF has returned 280%, while the second best performing assets are Treasuries, which returned 35%.

Over the same period, the S&P 500 has lost 30% of its value.

Gold is trading at record highs as more central banks announce their intention to buy the precious metal. Gold’s current uptrend through $1000 an ounce was started after the Indian central bank bought 200 tons of gold from the IMF, a move that signals that other banks might soon follow. The balancing act is then to hold gold steady as other dollar denominated commodities and assets roll through the ebbs and cycles that looks to still have further dollar weakness to yet come.

Disclosure: No positions