Gold and the U.S. Dollar: What's Next?

Includes: DGL, GDX, GLD, IAU, UDN, UUP
by: Daniel Zurbrügg

The question that seems to be the most common among investors lately is what is going to happen with gold and the U.S. dollar? We would like to address this question in a combined context.

Since the spot price for one ounce of gold is normally quoted in U.S. dollars, a further weakening of the U.S. dollar would cause the price of gold to increase, all other things being equal. Maybe that equation is simplified, but essentially for our analysis it’s sufficient.

The U.S. dollar has been trading in a very narrow range against major currencies and the volatility has been decreasing steadily. This is most obvious when one looks at the EUR/USD price graph. The price of EUR/USD has moved back towards the 1.40 level which means the U.S. dollar is weakening again and is now forming a new price floor around current trading levels.

In our view, this is a very negative sign for the U.S. dollar. It shows that when financial markets are performing well, and therefore showing increasing optimism in the outlook for the global economy, the U.S. dollar tends to fall. The correlation on this is actually very high and stable. This highlights the fact that the U.S. dollar is the most liquid currency and used whenever investors seek liquidity temporarily.

However, as financial markets and global economic conditions are expected to normalize (which does not necessarily mean improve), capital is flowing away from the U.S. dollar. This comes on top of the fact that the U.S. economy has significant structural weaknesses and heavy debt burden which will take a long time to improve.

Thirdly, there is also a “chronic” sales pressure which might emerge as global investors and central banks will look to increase their foreign exchange holdings and currency reserves away from the U.S. dollar. Currently, around 62% of global currency reserves are invested in U.S. dollar; we think that number could drop to less than 50% in the coming three years.

Further confusion is caused by statements from politicians and foreign central bankers who have, on many occasions, stated their preference for a strong U.S. dollar. We think these statements are political whitewash and that there is an official version and an unofficial version here. All of these players have significant U.S. dollar reserves which they look to lower in coming months. It’s understandable that they do not want the U.S. dollar to weaken before they had a chance to lower their exposure.

Therefore, our view on the U.S. dollar remains negative and we expect a further devaluation in coming weeks and months. This will of course also have a direct impact on the gold price, which would reflect a weakening U.S. dollar and therefore show a higher U.S. dollar price indication.

We recently discussed the uncertainty of investors not knowing whether deflation or inflation is the more likely risk in coming months. We think that the market’s focus could shift quickly from a deflationary scenario to a discussion about emerging inflation pressures.

In such a case, gold would certainly benefit as it seems an ideal hedge against a weakening U.S. dollar - as well as inflation. Therefore, it makes sense for investors to hold some gold in their portfolio for strategic reasons.

We expect the following for the U.S. dollar and gold:

  • U.S. dollar to break out of its current trading pattern and to weaken further
  • Increasing selling pressure from strategic investors looking to diversify
  • Gold to move towards $1,000 level in coming weeks and months
  • Temporary price corrections very likely but long-term uptrend to continue
  • Increased demand for gold as a strategic hedge and normalizing trade demand
  • Gold to move towards $1,300 level in 2010
  • U.S. dollar to move toward 1.50/1.60 versus euro