Must-know: Understanding gold price drivers (Part 4 of 12)
Inverse relationship between gold and the U.S. dollar
Gold and the U.S. dollar were associated when the gold standard was being used. During this time, the value of a unit of currency was tied to the specific amount of gold. The gold standard was used from 1900 to 1971. The separation was made in 1971. The U.S. dollar and gold were freed. They could be valued based on supply and demand. The U.S. dollar became a fiat currency—a currency that gets its value from government regulation, but isn’t backed by a physical commodity. It traded on foreign markets. The U.S. dollar was used as a reserve currency.
Gold moved to floating exchange rates after 1971. This made its price vulnerable to the U.S. dollar’s external value. In 2008, the International Monetary Fund (or IMF) estimated that 40–50% of the moves in the gold prices since 2002 were dollar-related. A 1% change in the effective external value of the U.S. dollar led to more than a 1% change in gold prices.
As the above chart shows, there’s an inverse relationship between the trade-weighted U.S. dollar and the price of gold. Trade-weighted value shows how the U.S. dollar is gaining or losing purchasing power—compared to its trading partners. However, this inverse relationship isn’t as precise as it used to be under the gold standard. Even though the gold standard is gone, there’s still a psychological tilt towards gold whenever the value of the U.S. dollar decreases. The inverse relationship remains because:
A falling dollar increases the value of other countries’ currencies. This increases the demand for commodities including gold. It also increases the prices.
When the U.S. dollar starts to lose its value, investors look for alternative investment sources to store value. Gold is an alternative.
However, it’s important to understand that it’s possible for the U.S. dollar and gold price to increase at the same time. This can occur because of a crisis in some other country or region. This would cause investors to flock to safer assets—the U.S. dollar and gold. The U.S. dollar is also driven by many factors—like monetary policy and inflation in the U.S. vs. other countries. It’s also driven by economic prospects in the U.S. vs. other countries. Investors need to consider all of these factors.
It’s important to get a sense of the direction that gold prices will take. Gold stocks like Goldcorp Inc. (GG), Barrick Gold Corp. (ABX), Newmont Mining Corporation (NEM), Agnico-Eagle Mines (AEM), Yamana Gold (AUY), and exchange-traded funds (or ETFs) like the SPDR Gold Trust (GLD) and the Gold Miners Index (GDX) are connected to gold prices.
Visit the Market Realist Gold ETFs page to learn more about investing in gold.
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