Gold functions with an inverse relationship with the U.S. dollar because gold is denominated in U.S. dollars in most financial markets. So naturally, since the dollar is down over the past decade, gold should be up. But why has gold risen so much? The dollar is down only 8.85% over the past year, yet gold is up 55% over the same period of time. What explains this?
The answer is found when you look to other currencies. Other factors matter, such as fear and the likelihood of default for major governments, but looking to other currencies makes things clear up the most.
For example, the Chinese Yuan has been allowed to rise in value versus the U.S. dollar over the past year, by about 5.5%. So one might think the Chinese are not manipulating their currency anymore and are making a genuine effort to create stable currency markets and redirect China to a more free market behaving currency. Not so fast.
The Chinese currency revaluation is only against the dollar, which is down almost 9% the past year. This means versus the rest of the world, the Chinese actually devalued their currency by 9%-5.5% = 3.5%. This means the Chinese are literally still printing money for their economy to function properly.
Gold represents a store of value which shows how much all of the countries in the world are printing money to survive. China isn't the only country doing this. The euro is down 7% versus the dollar the past year as well, but the dollar is down almost 9%. So versus the world ex-U.S., the euro is down nearly 16%. 16% is a large number, and begins to demonstrate why gold is up so much on the year.
In conclusion, the best way to value gold is to use all of the currencies in the world in comparison to the dollar. In other words, it seems the U.S. dollar is the base unit of economic measure in the world, and the other currencies in the world are often just leveraged upon the dollar, the Yuan is the classic example. The more foreign currencies in the world leverage up, the more gold should rise.
A bearish event for gold would be if the dollar was up versus the world, and then the Chinese Yuan and the euro were up versus the dollar as well. Supply demand factors involved with mining gold also plays a role, but the real key to use gold in a portfolio successfully is as a hedge against world stagnation in real growth accompanied by high currency growth.
As long as the largest economy in the world has a major currency account deficit, gold is unlikely to plunge anytime soon.
The gold ETF (GLD) is shown below with the dollar index ETF (UUP). You can see that just as I have said, gold seems to function as a leveraged instrument based on the inverse of the dollar. And the dollar itself is essentially the basis for all world currencies.
(Click to enlarge)
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
