Forex Traders Guide to Currency Strategy. The Inverse Relationship (and its Exceptions) between Gold and the Dollar.

May 15, 2010 by smsadmin · 3 Comments
Filed under: Forex

Gold and the Dollar

The relationship between gold and the dollar has long mirrored the decades-old battle between real tangible assets and financial assets. Traditionally the dollar has been the representative currency in any analysis of gold, due to its sustained role as the world’s reserve currency and the preferred means of exchange and invoicing transactions. The creation of the euro in 1999 and its subsequent ascent as a credible and strengthening currency has certainly started to challenge the dollar’s leading position among world currencies, but the euro has yet to dethrone the greenback from its dominating perch. Nonetheless, the probability of such occurrence has been gradually on the rise and may fully materialize as early as 2015.

Considering the 400-year historical connection between gold and paper currencies, the 100 years of dollar dominance, and the role of gold in initiating the present world currency order, it is appropriate to begin this book with the evolution of the relationship between gold, the dollar, and other currencies. Aside from examining the eventual trend between gold and the greenback, this chapter sheds light on how currency market participants can absorb the price developments in gold vis-à-vis currencies and equities in order to gain a better grasp of the cyclical shifts underpinning markets and economics.
During the final third of the nineteenth century, most countries abandoned the silver standard in favor of a gold-based currency standard. These moves were largely triggered by Germany’s receipt of a war indemnity from France in gold following the Franco-Prussian war, prompting Germany to unload silver on its trading partners. As Germany adopted the deutsche mark, backing it with a strict gold standard, most nations followed suit and opted for the metal. But the merits of the gold standard were in doubt after the British economy began to slump in the 1880s.
The gold exchange standard ultimately saw its demise in the 1920s when World War I disrupted trade flows and the free movement of gold. In 1931, massive gold withdrawals from London banks triggered Britain’s abandonment of the gold standard, and three years later the United States introduced the U.S. Gold Reserve Act under President Roosevelt’s New Deal. The Act reset the value of gold at $35 per ounce from $20.67 per ounce and ended the legal ownership of gold coins and bullion by citizens for over 20 years.

Gold-USD Inverse Relation
One of the most widely known relationships in currency markets is perhaps the inverse relation between the U.S. dollar (USD) and the value of gold. This relationship stems mainly from the fact that gold serves as an inflation hedge through its metal value, while the U.S. dollar holds its value via the interest rate commanded by it. As the dollar’s exchange value falls, it takes more dollars to buy gold, therefore lifting the value of gold. Conversely, when the dollar’s exchange value rises, it takes fewer dollars to buy gold, thereby dragging down the dollar price of gold. Unlike currencies, government bonds, and corporate stocks—all of which are determined by demand and supply as well as the issuing power of central banks and corporations—gold is largely dependent on demand and supply and is therefore immune to shifts in monetary and corporate policies and the new issuance of equity, debt, and currency.
While gold’s distinction from fiat currencies maintains an inverse relation with currencies other than the U.S. dollar, the negative correlation remains most striking against the U.S. dollar due to the currency’s dominance in central bank currency reserves. There are inverse relationship between gold and the dollar from 1970 to 2008. The highly inverse relationship between gold and the dollar between January 1999 and May 2008, highlighting a -0.84 correlation.

Recent Exceptions to the Inverse Rule
As with all close relationships between two assets, the USD-gold relationship has not been without its temporary periods of decoupling. The most striking break in the relation occurred between April and December 2005 when both gold and the dollar appreciated. The correlation had run as high as 0.66, showing a remarkably strong positive relationship. The explanation for this unusual correlation relates to developments pertaining to gold, the dollar, and the euro.
Gold was in the midst of a secular bull market that had started in 2001 and gathered strength in 2002 with the peak and the subsequent decline in the dollar. The rally was further intensified by the 2005 revaluation of China’s currency, which enabled it to step up appetite for gold and other commodities.
The dollar’s role in the temporary break in the USD-gold inverse relationship owed to the two-year campaign of U.S. interest rate increases (from June 2004 to June 2006), which lifted U.S. short-term interest rates above their Eurozone counterpart in the fourth quarter of 2004 for the first time in three years. As the U.S. interest rate advantage over the Eurozone was further widened by the Fed’s 2005 rate hikes, the U.S. dollar strengthened against the euro, especially as the European Central Bank maintained rates at a historic low of 2.0 percent.
Also contributing to the dollar’s 2005 recovery was a temporary tax break granted by the Bush administration to U.S. multinationals, allowing them to repatriate their profits from their overseas subsidiaries. The Homeland Investment Act, designed to improve job creation, slashed the tax on multinationals’ overseas profits from 35 percent to 5.25 percent. U.S. multinationals rushed to take advantage of the substantial tax break and repatriated an estimated $600 billion, prompting a surge of inflows into U.S. dollars from euros, especially in the second half of the year. Unsurprisingly, the temporary inflows of 2005 gave the dollar its best annual performance against the euro since 1999.
Since the euro makes up 58 percent of the dollar index, it is worth mentioning one factor specific to the Eurozone behind the euro’s 2005 decline against the dollar and other major currencies. France’s rejection of a proposed European Union Constitution dealt a blow to confidence in the European Union and the future of its currency, particularly because France is the second-largest economy of the Eurozone.

Tags: Forex Trading