For the past week, the price of gold has performed well. It has maintained its historic high and risen fairly sharply after breaking the $1000 mark. The main reason gold has performed well is because of its inverse relationship with the US dollar. Time and again we see any weakness in the dollar play itself out in the strength of the gold price.
Today we look at the inverse relationship between the dollar and gold. Below courtesy of stockcharts.com I’ve overlayed the gold price (dotted line) against the us dollar index (solid black line).
As you can see at the start of the year, in what is a very rare occurrence, both rose together. This was a brief rally as people sort ‘safe havens’. Once the initial fear of the credit crunch was overtaken by the realisation of the government’s plans to print more dollars, the demise of the dollar takes hold in what can be seen as a long term bear trend.
The gold price differs. You can see the brief rally in February to March was followed by a decline but then a gradual, sustained rise from January onwards shows once again the strength of gold in the face of the US dollar adversity.
Just like at the start of 2009 there have been times over the past decades where gold and the US dollar have not reflected an opposition to one another... In 1978-1980, during the biggest rally in gold’s history, the US dollar traded sideways. In this case gold was being driven by people’s fear of the world’s monetary system falling apart. People fled from all paper currencies not just the dollar.
There is an element of 1980 in 2009. Much of the same fear about global monetary destruction drives the gold price higher today. The main difference is that now we see dollar reserves accumulated across the globe in huge numbers. This concentration of dollars is unsettling the risk analysts at major market players like central banks who are finally turning their heads to see what else they can accumulate to offset the risk of a falling dollar.
The reason for the inverse relationship between gold and the dollar
The reason for the inverse relationship between gold and the US dollar is because both are seen as a global, worldwide currency. Pre 1971 the two colluded as a world gold standard whereby the US dollar and gold were pegged together. At that time one Troy ounce of gold could be swapped for US$35. In 1971 Nixon separated the two and effectively began the chain of events that ended with a floated US dollar (“Smithsonian Agreement”). This is a defining moment in the history of world economics. Before 1971 any central bank in the world could ask America to settle its debts in gold. Post 1971 they could only ask for US dollars.
What was the effect of decoupling the gold from the US dollar?
Central banks across the world started to stack more and more US dollars as this was the world reserve currency. As they did this the value of the dollar became imperative to the holders. Over many years the build up of dollars as a core part of the central banks reserves took hold. Today we have a world where there are far more US dollars in foreign bank accounts than there are in circulation in America. As the central banks added dollars to their portfolio the value of those assets became more and more in the interest of every central bank around the world.
Ultimately fears over the dollar’s instability are magnified by the quantity of holdings each central bank holds, hence the inverse relationship between gold and the US dollar is an effect of the popularity of the dollar as a world reserve currency.
The crippling nature of the central banks dependency on the US dollar is being debated amongst economists the world over. Currently we see various signs that the world is attempting to move away from its dependency on the US dollar but if the central banks stop buying US treasury yields and US dollars for their reserves the price of the US dollar could plummet.
If this were the case it could lead to the biggest implosion world economics has ever seen as more and more central banks, sovereign wealth funds, private funds and private investors sell to protect their portfolios. This is the risk.
Hedging against the dollar
With gold you have a global, accepted form of currency that has a limited supply. In this sense it makes a perfect hedge against the risk of the US dollar. Hence it is a far more obvious correlation to say that when the US dollar is weak gold is strong, whereas if gold is strong it doesn’t necessarily mean the dollar is weak.