It is undeniably true that the price of gold is related to the value of the US dollar, so it is essential to understand how this association has come about and exactly how the dollar influences the commodities markets if you are considering making an investment in gold. Understanding how the relationship between the US dollar and the price of gold works can help you to make the most advantageous investment decisions
China is buying gold
The Gold Standard
It is worthwhile spending some time considering the history of the relationship between gold and the US dollar in order to understand why they still hold such a pull over each other today. The association developed from the use of gold and silver standards to set the values of currencies in the past. In these monetary systems, the value of a unit of currency was tied to the value of a specific amount of gold or silver. The US dollar was originally tied to a bimetallic standard, based on both gold and silver, but it moved to a gold standard after 1900,which it remained on until 1971. The gold stabilized the value of the currency, but it had to be abandoned whenever the currency faltered, in order to protect the gold reserves. The ties were temporarily cut during the Civil War, the First World War and the Great Depression. Once the separation was made permanent, a new kind of relationship between the currency and the commodity arose, in which both were freed to play new roles in the global economy. The US dollar became a true fiat currency, traded on foreign markets and used as a reserve currency without risking the US gold reserves, while the price of gold was freed from the restraints that had been imposed on it by financial policies designed to keep currencies under control.
Will the US ever return to the gold standard?
An inverse relationship
The freeing of the US dollar from the gold standard has enabled it to fluctuate more widely, while the value of the gold remains stable, making it a safe harbour for investors in times of uncertainty, as a hedge against inflation and recession. The value of the gold remains stable in comparison to currencies, but its price in any given currency can fluctuate as the perceived value of that currency changes. The fluctuations in its price in US dollars reflects confidence in the currency, as the dollar revalues itself in relation to gold. Thus, the price of gold tends to move in opposite directions to the value of the US dollar. It is in understanding the subtleties of this relationship that an appreciation of the history of the US dollar’s association with gold can be useful, in order to predict when the inverse correlation is most likely to be triggered and how this can be used to one’s own advantage when investing.
The USD and Gold have historically traded as an inverse relationship
Confidence in Currencies and When It Fails
The historical association of the gold standard still holds a strong psychological sway over investors today and shapes the policies of many global banks. When the US dollar is in trouble, investors and global banks stocking their reserves tend to abandon it in favour of gold. Conversely, if the US dollar is appreciating, banks can begin to shift their reserves from gold into currency, raising the value of the dollar relative to gold. However, this inverse relationship is not as precise as the link between a currency and a gold standard. Fluctuations in the US dollar do not always show a negative correlation with the price of gold. For example, a crisis in another currency while the dollar remains stable can drive yo the prices of both gold and the US dollar as foreign investors use both as a safe harbour. The history of the currency’s relationship with gold, and particularly the manner in which the gold standard had to be temporarily abandoned during wars and depression in the past, can indicate the types of situations that will trigger the instinct to turn to gold and bring the inverse relationship into play, thus opening up investment opportunities.
When will the world see another currency crisis?
The Economic Crisis
One such opportunity arose with the onset of the global economic crisis in 2007-8, which triggered renewed interest in gold as a safe harbour investment. The example of the Great Depression enabled many investors and policymakers to predict this shift towards gold. Economic uncertainty during the 1930s drove up demand for gold so much that the government was forced to suspend the gold standard in order to prevent overseas banks from emptying the country’s reserves as they abandoned their reserves of US dollars in favour of the more reliable option. Another important factor that influenced the increase in the value of gold was the fact that it was at least in part, the abandonment of the gold standard that had enabled the wild fluctuations in the markets that gave rise to the crisis in the first place. Freeing the currency from the value of gold had destabilized the dollar in a manner that allowed enormous economic growth, but which also allowed bubbles of an unprecedented scale to swell and burst. Both the instinct to turn to gold in troubled times and the influence of an unfettered dollar on the crisis caused the demand for gold to grow. The flocking of investor the the safe harbours occurred early in the crisis, with money.co.uk noting increased interest in the reliability of gold and fixed rate bonds, and reporting that 31% of investors were predicting that gold prices would continue to rise even as record highs were reached in 2009. These predictions proved true, as confidence in gold continued to grow, and new issues raised even greater doubts about the security of the US dollar, to the extent that some commentators have called for a return to the gold standard in order to protect the currency.
Who will pay in the next economic crisis?
Trouble Economies Highlight Stability of Gold
Any looming economic trouble that is expected to affect the value of currencies such as the US dollar will create a shift towards gold. The approach of the US debt ceiling is no exception to this rule, and it has the potential to create another climb in the value of gold as confidence in the US dollar is shaken once more. Even if a solution is reached in time, many investors will remain cautious about the US dollar. Meanwhile, the price of gold has been demonstrating its inverse relationship to confidence in the currency particularly clearly as opinions about the course of negotiations has shifted between optimism and pessimism over the course of the crisis. Whenever optimism, that a solution is near peaks, the price of gold drops a little. Gold futures fell to a three month low early on October 15 as expectations of a solution appearing drew investors away from safe harbour options. However, any indication that negotiations are stalling or that the deadline for a solution may be missed, results in a move in the opposite direction. Indications that disagreements were arising once again in the house, causing the effort to find a solution to the debt ceiling crisis to stall once more, resulted in a rise in the price of gold during afternoon trading on the same day. Gold looks set to remain an important safe haven in the near future, even if an agreement can be made to raise the debt ceiling and shift this problem forwards into the future. The fluctuations that have occurred as a result of the debt crisis only serve to emphasize the importance of gold as a safe haven from the troubles that plague the economy.
By James Fraser
Co-author Mining Stocks Guide