How Gold Performs During A Financial Crash

 |  Includes: CNY, ERO, FSU, GLD
by: Plan B Economics

Over the past couple weeks, gold has fallen from a high of around $1920/oz to an intraday low of around $1730/oz (about a 10% drop). On Sept. 22, 2011, alone gold fell about 3.7%. This has happened as the global economy marches ever closer to Lehman 2.0 – a three-pronged collapse of the European banking system, the US economy and the Chinese economy. I am being inundated with questions from people wondering why gold is falling as the financial crisis worsens. After all, isn’t gold some sort of safe haven?

The first thing investors need to understand is that gold is priced in US dollars. This means that as the dollar rises the price of gold falls, all things being equal. The dollar is quickly rising because it is a safe haven (US Treasuries are a safe haven that must be purchased in US dollars) and because asset liquidations around the world are gaining speed causing a growing shortage of dollars.

The second thing investors need to understand is that gold, as an asset that has performed well, is a source of funding for margin calls made on declining assets. This means that gold is undergoing a degree of "forced selling."

One only has to go back a couple years to see how gold reacts during a financial crisis. The chart below shows the price of gold during the financial crisis that arguably began with the collapse of Bear Stearns in March 2008. (There are multiple ways to define the true start, but I had to draw a line in the sand and the first major i-bank collapse sounded like a good place to start.) During this time, gold prices fell by about 25% and subsequently recovered all losses. This was a scary ride for anyone holding gold at the time, but it’s an incomplete view of gold’s performance during the crisis.

The second chart below shows gold during the same period priced in US dollars, euros and Canadian dollars (indexed to 100 for comparison purposes). During the 2008/2009 crisis, as the US dollar was rising while the euro and Canadian dollar were falling and this is reflected in the different gold prices. Gold priced in Euros and Canadian dollars fell less and recovered faster than gold priced in US dollars. This is precisely because the US dollar was so strong during that period. However, as the monetary response began to unfold (QE1 announced December 2008) and trillions of US dollars were unleashed to backstop the financial system, gold in all currencies began to rally dramatically.

Really, the basic steps are straightforward:

  • Economic/financial crisis leads to asset liquidation and dollar shortage
  • Dollar shortage leads to dollar appreciation and gold depreciation (in dollar terms)
  • One form of asset liquidation – forced gold selling – leads to gold depreciation (in all currencies)
  • Eventual monetary response creates surplus of dollars
  • Surplus of dollars causes dollar depreciation and gold appreciation

For US investors, in my opinion, a crisis in which a skyrocketing dollar sends gold plummeting in US dollar terms could create a big gold buying opportunity, like it did in 2008. That said, the basic steps outlined above could take months to fully materialize. The market is disappointed (read: impatient) with the Fed's lackluster curve-flattening program (i.e. Operation Twist) because it delays the possibility of additional quantitative easing. However, as the economy continues to deteriorate, the probability of QE3 rises - this process could take a long time, and the Fed won't act until it must act. The Fed simply no longer has the credibility and political support to act boldly and pre-emptively, so it must wait until there's blood in the streets and politicians are begging for relief.

Note: For non-US investors that own gold, pay attention to the price of gold in your domestic currency because, unless you’ve hedged, your exposure is relative to your home currency, not US dollars.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I am long gold. This is not advice. While Plan B Economics makes every effort to provide high quality information, the information is not guaranteed to be accurate and should not be relied on. Investing involves risk and you could lose all your money. Consult a professional advisor before making any investing decisions.