Debunking The Theory That The U.S. Dollar And Gold Have An Inverse Relationship

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 |  Includes: AGOL, GLD, IAU, OUNZ, SGOL
by: SomaBull

Summary

Many economists, analysts and investors believe that the US Dollar and Gold trade inverse with each other.

History shows us that the Dollar and Gold don't have this correlation.

A truly inverse relationship wouldn't be possible in an inflationary environment.

Gold follows the money supply, nothing else.

There are many investors out there that like to purchase SPDR Gold Trust ETF (NYSEARCA:GLD) and/or Gold to protect themselves from inflation, a declining Dollar, or just general market uncertainties. When the Dollar starts to rise many assume that this is negative for GLD/Gold. I'm sure you have heard it before, if the Dollar goes up then Gold goes down, and vice versa. If you watch any of the financial news networks or read any financial publications, this "rule of thumb" is expounded constantly. But in reality this isn't the case. And in actuality, it would be impossible for the US Dollar and Gold to trade inverse with each other.

The Evidence

First let's take a look at a chart of the USD and Gold. As you can see below, in the last 8 years the USD is flat while Gold is up over 200%. How can this be if they trade inverse to each other?

Click to enlarge

(Source: Stockcharts.com)

Let's extend this chart out a little. Below is the USD vs. Gold from 1970 to 2012. In 1978, the US Dollar Index was at 85, Gold was around $200. In 1980, the USD was still 85, Gold was at $800. Where is the inverse correlation? In the early 90s, the USD was again around 85, Gold was $400. While not shown on the chart below, in 2013, the USD was at 85, gold was at $1,200. So we have had Gold at $200, $400, $800, and $1,200 while the USD was at 85. The fact is gold doesn't trade inverse with the US Dollar Index.

Click to enlarge

(Source: Sharelynx.com)

Why The Assumption?

We first have to ask why so many economists, analysts, and investors believe this. The theory is, a rising Dollar makes investing in Gold/GLD less attractive, as a strong currency means less monetary and economic uncertainty. And conversely, a falling Dollar makes investing in Gold/GLD more attractive, as a weak currency means inflation and economic uncertainty.

There are two major flaws in this theory. The fact is global currencies are all being debased, and a strong currency still means inflation.

A Race To The Bottom

In 2008, we almost had a complete meltdown of the entire financial system. If it wasn't for the quick action by the Federal Reserve and other central banks around the globe, we would have had a severe depression. Some would argue that is exactly what we needed to do to clean the system, but that is for another article.

Trillions upon trillions of fiat currencies have been printed by the major central banks since 2008. This is a race to the bottom, there is going to be no winner in all of this. If the US Dollar goes up, it just means it's the best of the worst.

Let's take a closer look at the US money supply, M1 and M2. As you can see below, M1 has exploded since 2008. In theory, the US Dollar should be down given this growth in money supply.

Click to enlarge

(Source: FRED)

Now, let's look at M2. I added the red line into the chart below to show the trend line for M2 growth over the last 35 years. You can see that from 1980 to early 2000s, M2 stayed close to this trend line. Then around 2005 it was above it, and in 2014 it is substantially above the normal trend. M2 should be around 7,500, instead it's over 11,000.

Click to enlarge

(Source: FRED)

The US Dollar Index has moved higher in the last 5-6 years since the 2008 Financial Crisis, and is up a lot from the 2008 lows. Given the money supply growth (which is inflation), the Dollar should be lower, but it's not. The reason is because every other major currency in the world is also being debased by the trillions, just like the USD. The US Dollar just happens to be picked as the best of the worst right now.

A Strong Currency Still Means Inflation

This is probably the most important point that debunks the theory that the US Dollar and Gold trade inverse to each other. Having an inverse relationship is just impossible over the long-term. Why? Because in a non-Gold backed currency you always have inflation. It costs money to produce things. Cars, electronics, houses, etc., it's no different for Gold.

The costs to produce one ounce of Gold was under $100 for many mining companies back in 1975.

(Source: The Financial Post)

Today, the total production costs on average are around $900-$1,000, with all-in costs around $1,200 per ounce.

Click to enlarge

(Source: GFMS)

It's this simple reason alone that Gold will never trade inverse with the US Dollar. It can't. In a non-Gold backed currency, the cost to produce anything and everything is going to rise over time. How much did it cost to build a car back in 1975, or a house? A lot less than it does today. The same goes for Gold. The cost of production is always going to increase over time. You can't have Gold at $500 when it cost $1,200 to produce it. That would be like cars selling for $10,000 today yet it cost $24,000 to build, or a house selling for $50,000 yet it cost $120,000 to build. There would be no car manufacturers or home builders if that was the case. And there would be no Gold miners either.

An Example

To drive home the above point, let's use an example. Let's say the US Dollar steadily increases over the next 20 years, going from around 82 today, back up to 120 or so which is where it was at in 2001. What would the price of Gold do during that time? According to theory, it would have a big decline. How much of a decline? $500? In 2001, it was at $250-$300 per ounce when the USD was at 120, so does it go down $1,000 over the next 20 years?

Think about that, and then think about the current costs to produce 1 ounce of Gold, and the fact that we have around 2% inflation per year in the economy. Which means production costs are going to continually rise over time. If you believe that wages, oil, machinery, steel, etc., are all going to decline in price drastically over the next 20 years, even though it has never happened before in a 20-year time period of a non-Gold backed US Dollar, then Gold production costs would decline as well. But since we deal in realities, the costs of those things will increase over the next 2 decades, hence so will the costs to produce Gold.

The Value Of The Dollar Will Always Decline, But The US Dollar Index Might Not

The purchasing power of the USD has eroded greatly over the last 80 years. In 1971, the US went completely off of the gold standard, which set the stage for a massive amount of inflation and loss of purchasing power for the US Dollar.

Click to enlarge

(Source: Goldchartsrus.com)

While it's possible that the US Dollar Index might not go down anytime in the next 20 years, the value of the Dollar most certainly will. They are two separate things. That's what people get confused about. Gold measures the purchasing power of the US Dollar, not where the US Dollar is trading against a basket of other fiat currencies. That's why there is no correlation with Gold and the US Dollar Index.

If the Fed came out tomorrow and said it was going to print $2 trillion, and the ECB, the BoJ, and the BoE all came out and said they were each going to print $4 trillion, then the US Dollar Index would go up. However, the purchasing power of the USD compared to Gold would go down given the increase in the amount of currency that was created. Gold would rise even though the US Dollar Index was also moving higher.

Follow the Money Supply If You Want To See Where Gold Goes

An increase in the money supply is inflation, pure and simple, and Gold is going to follow the money supply. In 2008, when the US got a whiff of possible deflation, Gold was crashing. When M1 and M2 took off after the Fed unleashed the printing presses, so did Gold.

Click to enlarge

Gold doesn't follow the money supply to a "T", it will have wild gyrations above and below it, but over time Gold will continue to trend higher with it.

We live in an inflationary system, and you will never see M2 decline or remain flat for too long. Only going back on a Gold standard would bring back the possibility of deflation like we had in the 1930s and during periods in the 1800s.

Conclusion

The theory that Gold/GLD and the US Dollar trade inverse to one another is wrong and in actuality, it would be impossible for this to occur. There is no evidence that this correlation exists over the long-term.

There are two major flaws in this theory. The fact is central banks around the world are massively debasing their own currencies, it's not just the US. This is a race to the bottom, the US Dollar is currently rising, but that just means it's the best of the worst for the time being. A strong currency still means inflation. Everything costs money to produce, even Gold. With production costs of an ounce of Gold increasing with inflation, the price of Gold will have to continue to increase, irrespective of what the US Dollar Index does.

The US Dollar Index might not go down, but the value of the Dollar always will. They are not the same thing. Gold measures the purchasing power of the US Dollar, not where the US Dollar is trading against other devalued currencies.

Gold follows the money supply and money supply growth is inflation. Since the US isn't on a Gold standard anymore, then M2 will continue to rise unabated.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.