What Is Going On With Gold?

Includes: CNY, FXE, GLD, IAU, UUP
by: Cullen Roche

Gold (ETF:GLD) is one of the most fascinating and talked about assets on the planet. There are more conspiracy theories and story lines behind gold than just about anything on earth. Heck, the followers of the asset even have their own club: the goldbugs. You can't go a day without seeing a commercial about gold. If you google "buy gold" you get almost as many results as if you search "buy real estate" (15.4MM vs 16MM).

But gold has been acting funny lately. The conspiracy theories have been running even crazier than usual (from government conspiracy to backwardation) and the goldbugs are angry. As the world economy deteriorates and the U.S. prints money like it's going out of style, gold has not appreciated. If you had told me in December of 2007 that the global stock market would fall 40% in 2008 I would have told you to buy gold and nothing else because of its safehaven characteristics. But a funny thing happened on the way to the demise of the global economy: Gold fell.

After rallying into the second quarter of 2008, gold went on a gut wrenching 6 month decline of over 30% - all in the midst of one of the greatest financial collapses ever. It was, if nothing else, quite a paradox. Even crazier, the US dollar stabilized and then rallied into the end of 2008. Why did this happen? How could gold fall in such an environment?

Gold remains an anti-dollar investment. It's as simple as that. When you buy gold you're essentially buying a hard asset currency with the hope that one day it will become the world's choice of currency again. If the dollar (NYSEARCA:UUP) weakens or one day fails the likelihood of a gold based currency increases. In essence, buying gold is a way of betting against the greenback and U.S. economic dominance. You can argue the extent of my argument, but you can't really argue with the inverse correlation in the two assets:

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The correlation is clear. If you're betting on a rise in gold you're betting on a falling dollar. I've been banking on a higher dollar for over 6 months for one reason: it's the best currency in a bad lot. Jim Cramer should change his area of expertise to currencies, because while there isn't always a bull market in stocks and commodities, there is always a bull market somewhere in the currency market. Trades are paired in Forex and unfortunately, it's hard at this time to make an argument in favor of other currencies over the greenback. And as long as the greenback remains strong it's unlikely that gold will make any sustainable run.

So why is the dollar the best of the worst? It's quite simple in my mind. Two major currencies on the planet now effectively bear zero interest: the dollar and the Yen. Of the two, the U.S. is the far superior economy. In essence, neither country can really devalue their currency all that much more unless they decide to print money to the point of insanity and although I believe the U.S. is printing wildly I am not incredibly alarmed as of yet simply because the destructive deflationary forces at work are so much greater than the inflationary response by the Fed. Inflation is certain to rear its ugly head in the coming years, but I suspect it will be relatively mild as the economic rebound is slow and the overall monetary destruction of this deflationary phase proves to be incredible.

So, getting back to the greenback - the U.S. was first to enter a recession and it now looks like the world is catching pneumonia from our cold. Unfortunately Europe and Asia still have relatively high interest rates (read: room for currency devaluation) and simply don't carry the same status as the U.S. - we are the reserve currency and the only true AAA nation. Yes, you can certainly make the argument that the U.S. is no longer a AAA rated country, but if we're AA then what does that make Japan (the world's second largest economy) or Germany? Much worse, in my opinion.

So what we're seeing is essentially a flight to quality in a time of financial distress? Yes, that's right, the U.S. dollar is a higher quality asset right now than just about any currency on the planet. And if you're a U.S. citizen you should be thanking your lucky stars it's THE reserve currency because this crisis would likely be even worse if that wasn't the case.

So, before you go placing bets on gold it might be better to research the greenback first.