Gold & The US Dollar (Part I)

Let's begin with a simple model and discuss the connection between gold and the US dollar, as this displays the two extremes of money.

On one side, we have the most significant complex investment, mainly metal, while on the other, we have the prior soft help of fiat paper-based money. Both are deemed safe havens, with gold having the added advantage of hedging against inflation. In addition, of course, the cost of gold is also affected by purchasing demand, particularly from India and China.

Gold & The US Dollar (Part I)

Two Gold players

India has its own gold purchasing 'season,' which commonly begins in early October and runs to the end of the calendar year, which is frequently mirrored in the cost of gold. With jewelry making up almost 70% of the world's gold market, India is at the top of the index, even more so lately with the surge in the middle ranks.

China, too, is adding importance to the demand for the precious metal, and in 2012 Chinese citizens were now allowed to invest in gold directly for the first period in history. Both these countries now have a fierce desire for gold which is continually growing. And China newly reported it, too, would establish an ETF backed with physical gold.

We must first understand the association between gold and the US dollar as forex traders for two reasons. First, this association is human and, therefore, highly exposing.

Second, gold supplies the bridge between capital and all the other markets as the most refined. It is a direct connection, since gold, like almost all other commodities, is priced in US dollars. Consequently, a trend change in one will likely have an immediate and rapid change in the other.

This must be corrected when viewing other connections between the various capital demands. We require some bridge to investigate the results of money flow and danger—a linking mechanism, if you like, between two globes. Commodity demands are one such bridge, linking the world of money with the economizing and market view.

Since removing money from the gold norm in the 1970s, the textbook connection between gold and the US dollar has been inverse, with gold increasing on US dollar liability and, contrarily, the US dollar boosting as gold prices drop.

The explanation for this is twofold. First, as gold is priced in US dollars, then as the currency cuts, the cost increases, and vice versa. In other words, a feebler dollar lets you buy more gold for the same number of dollars.

Second, it's all to do with inflation. Inflation is the double-edged blade with which the central banks control economies. It is not only a double-edged blade but also an exceedingly blunt tool. Also, it is the only tool the central banks have to make relatively stable and healthy economies helping to create jobs. Inflation is exemplary, but too much is horrible, and inflation is formed using another blunt tool, namely welfare rates.

In many methods, inflation must be like Goldilocks porridge – not too hot or freezing. Too much and the economy overheats, the brakes are involved too late, and a slump ensues. Too little and no growth happens.

Inflation also conveys capital erosion in real terms, which is where gold grades in as a barrier against inflation. Eventually, gold also serves one other objective – it is the ultimate haven for money in economic apprehension or market turmoil.

But for now, let's focus on the association between the US dollar and the cost of gold. Wouldn't it be wonderful if this relationship could consistently be counted on? Sadly, it can't – and like numerous other cross-market associations, these can and do break down periodically. And while the inverse association between gold and the US dollar is powerful, it is not infallible.

Allow us to step back to the beginning of the subprime mortgage problem, which saw an avalanche of pots and mortgage businesses tumble in the US and elsewhere. This was swiftly tracked by a worldwide slump (if not depression), European sovereign debt ruins, and historically low-interest rates in most Western countries.

Throughout this time, the gold/dollar connection was punctuated with times when gold and the US dollar moved higher or both pushed lower, with a resulting return to the inverse relation shortly after that.

The time to view is from February 2010 to September 2010 and plots the gold vs. US dollar relationship. As we can notice, gold was growing along with the US dollar from February 2010 until June 2010, obeyed by two months when both gold and the US dollar dropped.

In other terms, the association had shifted from an inverse correlation to a natural positive correlation over this time, and the query is WHY, given that shortly after in September that year, the connection retreated to standard, with gold increasing and the US dollar dropping, a relationship that has remained unchanged since.

So why did we see the pair 'decouple' from the standard? Let us try to describe it.

Early in 2010, the sovereign debt problems in Europe started to surface. Nations such as Greece, Portugal and Ireland, and, latterly, Spain (all directed to as the PIGS) faded into the demands they were in severe financial problems.

The possibility of default in an EU member condition was honest and even more likely without permission from the European Central Bank. This was something other than what the EU or ECB could even view.

The demands responded negatively to the information, selling the Euro, buying the US dollar, the haven currency, and shipping the US dollar higher.

But in addition, investors also purchased gold as the most extraordinary haven, pushing the cost of gold higher, along with the US dollar. This buying of both investments persisted into the summer. At that point, the US economic vision began to defeat, with the Federal Reserve hinting at a different quantitative easing game.

Conclusion

This procedure mentioned above, it was expected, would stimulate the economy by creating an atmosphere for development and drive inflation into the design, but also assure that the US dollar slipped, making exports more affordable. Consequently, more frugal exports would help US businesses with overseas operations enhance their profitability.