The Dollar-Gold Relationship

Anyone who follows the gold and currency markets closely will realize that the
US$ gold price and the Dollar Index generally trend in opposite directions; or, to
put it another way, that the US$ gold price and the Swiss Franc generally trend in
the same direction. This reciprocal relationship between gold and the dollar is
often not evident on a daily or weekly basis, but is almost always evident during
periods of 12 months or longer.

The reason that gold and the dollar generally trend in opposite directions is that in
one respect gold is just another currency. It is no longer money in the true
meaning of the word, but it tends to trade as if it were. As a result, when the
dollar weakens on the foreign exchange market over an extended period then the
US$ gold price will generally rise during the same period; and when the dollar
strengthens over many months the US$ gold price will usually fall. There are, of
course, leads and lags and there's no reason to expect that percentage changes in
one will be accompanied by equal-and-opposite percentage changes in the other,
but when charts of the dollar and gold are compared it quickly becomes apparent
that the two have been inversely correlated since the floating -- some would say
sinking -- currency system came into being in the early 1970s.

In discussing the dollar-gold relationship in the above paragraphs we used the

words "generally", "usually" and "tend" because over the decades there have been a
few periods when gold and the dollar have NOT trended in opposite directions. One
such period occurred between May and November of 2005, prompting many gold
bulls to proclaim that gold had de-coupled from the dollar. However, this proved to
be just a 6-month aberration within a 10-year period during which the traditional
relationship was very strong.

Another period during which the traditional inverse relationship broke down was
May through to December of 1993. As illustrated by the following chart, gold and
the Dollar Index had a strong positive correlation during the aforementioned
period.
The most pronounced divergence of all from the traditional gold-dollar relationship
occurred during 1978-1980 and is clearly evident on the following chart comparison
of the US$ gold price and the Swiss Franc (the SF/US$ exchange rate). The
chart shows that the best gold rally of the past 100 years -- a rally that took the
gold price from $200/oz to $800/oz in the space of just 14 months -- occurred
while the US$ traded sideways relative to the Swiss Franc. In this case, gold was
not driven upward by weakness in the US$ relative to other paper currencies, but,
instead, by fears that the world's monetary system was coming apart at the
seams. There was a mass exodus from all paper currencies and one of the main
beneficiaries was the substance that had invariably been chosen by the market to
perform the role of money during those historical periods when it had been free to
choose.

We suspect that gold's best gains during the current secular bull market will
ultimately come in response to the same sorts of fears that led to the dramatic
1978-1980 price surge. In any case, the point we really wanted to make is that gold
never actually de-couples from the currency market because the investment
demand for gold -- the only thing that really matters as far as gold's
intermediate- and long-term price trends are concerned -- is inexorably linked to
what's happening to the official currencies. Most of the time gold responds to
trends in the dollar's foreign exchange value, but there are also times when it
responds to changes in the general level of confidence in paper money regardless
of whether the US$ happens to be a relatively weak or a relatively strong
currency.

The Dollar-Gold Inverse Relationship

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.

The worrisome relationship between a strong stock market

and a weak dollar:
The dollar drops and stock rise. If the dollar is supposed to be a reflection of
economic strength, this should tend not to happen.  David Goldman explains it:

Something ominous is at work here. Typically, a stronger dollar goes together with
a stronger stock market. That is what we observe prior to the bank bailout last
fall. Starting in the third quarter of 2008 and going to the present, the
correlation turns sharply and persistently negative. A cheaper dollar means higher
stock prices, as US assets are marked down for global investors.

What we have is not a stock market rally but an adjustment to global market
prices. Fully 80% of the movement in the S&P can be explained by the movement in
the dollar index.

That is a profile well known to emerging market investors. Whenever the Brazilians
would pull another currency devaluation, stock prices rose to compensate, as
tradeable assets floated up to world market prices. The bank bailout has made
Americans poorer relative to the rest of the world and created the illusion of a
stock market recovery.

That does not necessarily mean that inflation will return to the US, as some
analysts believe. Foreign investors are not likely to buy homes in Cleveland
(although the dollar devaluation certainly should help real estate prices in New
York or San Francisco). And the combination of high unemployment and deferred
retirement (greeter jobs at Wal-Mart will be in great demand) will keep wages
down. The price of international tradeables, though, will affect US inflation, which
is why I continue to recommend classic commodity hedges (including gold and oil)
rather than TIPS.

FOREIGN EXCHANGE:
FOREIGN EXCHANGE “The Currency Market where money denominated in one
currency is bought and sold with money denominated in another currency”.
Exchange rates are important because they enable us to translate different
counties’ prices into comparable terms. Exchange rates are determined in the same
way as other asset prices.

RELATIONSHIP BETWEEN FOREIGN EXCHANGE &

STOCK MARKET:
The equity market can impact the currency markets in many different ways. The
direct relation between foreign exchange market and the stock market.

DIFFERENCE BETWEEN FOREIGN EXCHANGE AND

STOCK MARKET:
Greater leverage No middlemen Buy/Sell programs do not control the Market
Same price for broker assisted trades Trade with real time profits

A very important factor in determining the direction of equity markets and

movement of other asset classes globally is the movement of the U.S Dollar. In
this article I would discuss this relation between the Dollar and asset classes
globally. This would help investors in figuring out the near term direction of equity
and commodity markets.

In order to make this relation clear, presented below is a five year Dollar index
chart. Dollar Index is the measure of the value of the U.S. dollar relative to
majority of its most significant trading partners currencies namely the euro,
Japanese yen, Canadian dollar, British pound, Swedish krona and Swiss franc.

Five Year Dollar Index Movement Chart (Chart Source:

Bloomberg)

Key Observations:

 Between early 2006 and July 2008, the Dollar Index witnessed a sharp
slump. This is the period when equity markets and commodity markets
surged. The global equity markets started to go down primairly from January
2008. However the commodities went up and peaked out only in July 2008.
This is the time when the Dollar Index bottomed out.

 July 2008 onwards, the Dollar Index started to move upwards. During this
phase the global equity and commodity market suffered one of the worst
downsides. The Dollar Index peaked out during the first week of March
2009. This is the time when most of the global equity markets bottomed out.

 Since 10th March 2009, the Dollar Index has been sliding downwards. During
this time the global equity and commodity markets have surged. Some Asian
markets are up almost 100% from their bottom. Similarly, many commodities
are up over 100% from the bottom they made in March 2009 and in some
cases December 2008.
Reason for this Inverse Relationship between Dollar and
Other Asset Classes:

The global economic boom that was witnessed during the period 2003-2008, was
largely due to the outflow of Dollar from U.S. to the rest of the world driven by
its consumption. This lead to excess global liquidity, which was absorbed primarily
in emerging market asset classes.

However, the credit crisis and the subsequent slump in consumption in the U.S lead
to a tightening of liquidity. There was relatively much less Dollar flowing from the
U.S to the rest of the world. This lead to appreciation in Dollar and the slump in all
asset classes.

This upside again reversed as the U.S. Federal Reserve pumped in billions of Dollar
into the system. Again with ample supply of Dollar, the Dollar index slumped and all
the excess Dollar in the system was absorbed through inflation in asset classes
(primairly equities and commodities).

Conclusion:

The Dollar Index movement can be used by investors to get an idea of the
direction of movement of equities and commodities.

 Any rise in the Dollar index is generally a near term sell signal for asset
classes.

 On the other hand, if the Dollar keeps falling against major currencies, then
asset markets will be supported through this weak Dollar.

6 Factors That Influence Exchange Rates: Aside from factors

such as interest rates and inflation, the exchange rate is one of the most
important determinants of a country's relative level of economic health. Exchange
rates play a vital role in a country's level of trade, which is critical to most every
free market economy in the world. For this reason, exchange rates are among the
most watched, analyzed and governmentally manipulated economic measures. But
exchange rates matter on a smaller scale as well: they impact the real return of an
investor's portfolio. Here we look at some of the major forces behind exchange
rate movements.