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September 26th 2009

Dollar Down, Gold Up

As an unintentional extension to an earlier post (Dollar Down, Everything Else Up), I want to use this post to highlight the appreciation of gold in particular, against the Dollar. After a brief decline following the credit crisis, Gold has resumed its upward path. It has appreciated 15% year-over-year, and recently cracked $1,000/oz for the only the fourth time in history.

The general factors behind the price of gold are too broad and numerous to be captured in this post. In addition, many of these factors have little to do with currencies (including the Dollar), and thus don’t warrant much space on a blog devoted to forex. At the same time, conspiracy theorists, doomsday predictors, and even some mainstream economists have long argued in support of gold as a hedge against inflation (otherwise understood as currency devaluation). In fact, I am only posting about gold now is because that notion has become much more popular over the last few years, to the point where pundits have come to see the current appreciation almost solely in terms of the decline in the Dollar.

That’s because many of the more conventional factors – the same ones that affect prices for other commodities – suggest that gold prices should be declining. Non-speculative demand (i.e. jewelry, industry) remains subdued as a result of the economic recession. Speaking of which; while there is now some evidence of recovery, it is nowhere near robust enough to support a return to bubble prices. In addition, the International Monetary Fund (IMF) just approved a massive sale of its gold reserves, equivalent to 15% of the world’s annual gold production.

Yet the price of gold remains not only stable, but positively buoyant. According to analysts, this is because of an increasing sense of anxiety about the viability of the Dollar as the world’s reserve currency. Euro Pacific Capital’s Peter Schiff, an effusive source of commentary on the markets, believes the price of gold will skyrocket to $5,000 per ounce. “Schiff’s forecast is based on his view the U.S. dollar is going to collapse under the weight of our massive deficit and reckless policies of the Obama administration, which he compares to the massive spending programs of the 1960s, which paved the way for gold’s ascent in the 1970s.”

Other analysts take Schiff’s view one step further by arguing that a shortage of viable alternative reserve currencies (Euro, Yen, Pound, Yuan, etc are plagued by similar fundamental flaws as the Dollar) makes gold the best candidate to replace the Dollar. Some people even hold the extreme view that the entire fiat monetary system will collapse, with the result being a barter system centered around gold. In any event, people are nervous: “That means a growing number of investors, traders — and, most troublingly, foreign governments — don’t believe in the strength of the U.S. dollar, analysts warn. People buy gold when there’s fear.”

On the other hand, it seems reasonable that gold is appreciating for the same reason that everything else is. In this sense, rising gold prices are hardly remarkable. Silver and platinum, for instance, have risen nearly 50% year-after-year, despite similarly weak fundamentals. There is a danger in connecting the Dollar’s decline too closely with the rise in gold, since the former is largely a function of short-term factors such as low interest rates and increasing risk appetite. “With the Fed confirming that interest rates could be steady for a long time, the dollar may continue to be dumped in favor of higher yielding currencies, which may favor the yellow metal.”

While there’s reason to be alarmed or even angry about deficit spending, quantitative easing, money printing, and unsustainable debt, there’s very little to support the notion that inflation is taking hold.  In fact, based on both Treasury bonds and inflation securities, inflation is the last thing on the minds of investors. In addition, while gold represents a conceptual reserve commodity, it’s not very practical. It has very little utility (especially compared to other commodities), and its supply can be easily manipulated by producers and central banks. One analyst explains, “Even a rather wobbly reserve currency is better than gold. Gold is far less liquid than U.S. Treasury securities, costly to store and insure, and above all more volatile in price.”

Still, perception is reality in financial markets. If investors want to see a connection between a weak Dollar and strong gold, they will simply contrive one. But if the Fed raises interest rates and/or the Dollar stabilizes, you can expect gold prices to follow suit. If this happens, it won’t imply that confidence in the Dollar has been restored. Instead, it will only imply that investors can earn a higher return investing in Dollar-denominated assets and no longer need to speculate in gold.

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Posted by Adam Kritzer | in Features, News, US Dollar | 8 Comments »

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8 Comments of “Dollar Down, Gold Up”

  1. Bertie Says:

    Is there enough gold in the world to use it as a reserve currency?

  2. Adam Says:

    I have been enjoying the dollar falling, although when it turns will it turn fast and destroy my profits?

  3. fluffy Says:

    “Is there enough gold in the world to use it as a reserve currency?”

    Sure, just revalue gold to $50,000 per ounce and that should do the trick.

  4. hishamh Says:

    The question isn’t one of quantity but of valuation. Yes, there’s enough gold to function as a reserve currency, but not at current prices – you’ll have to increase the gold price from between five to six-fold to fully back money defined as M2.

    A far more pertinent question is the impact on monetary management and economic activity of having gold-backed currency. The growth in gold supply lags economic activity by a fair bit, which implies future gold prices have to increase continuously – in short, deflation.

    If we had the gold standard right now, we’d probably have currency stability, but we would also guarantee that the world would fall into another Great Depression.

  5. Naumdar Says:

    There may be “enough” gold, but it is very problematic and unlikely to be used as a reserve currency. The end of this article is illustrative:

  6. Shaun Says:

    Historically the correlation with a currency and gold is a clear sign of the devaluation of that currency. My call is that the dollar is going to be worthless in the future and the smart money knows this and are investing in gold to protect their portfolios. Hyperinflation is a possibility based on the technical and the fundamentals on the dollar index and it’s relation to the global markets.

  7. t Says:

    More than enough…

  8. Inverse Correlation between Dollar and Everything Else…Still | Forex Blog Says:

    […] two months ago, I wrote a series of posts (Dollar Down, Everything Else Up and Dollar Down, Gold Up) with self-explanatory titles. Last week, the Wall Street Journal finally got around to covering […]

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