Why the Dollar & Gold Are Out of Sync, Why They Won't Be For Long By Stephen Clayson 02 May 2006 at 02:34 PM EDT
LONDON (ResourceInvestor.com) -- Within a recent piece by one of my fellow correspondents reminding investors that the dollar and gold are not moving in an exact inverse lockstep, it seems apposite to examine the reasons why this is the case. This set of explanations does not however include the invalid but often advanced argument that the dollar and gold have decoupled.
One factor is clearly the existence of interest rate differentials, a subject I delved into previously. The Federal Reserve Bank of the U.S. may be bringing to an end its phase of consistently raising interest rates, which have of late been attracting funds into the dollar rather than alternative currencies that offer lower interest rates but are not fundamentally overvalued. The possibility that the end of this period of rate tightening is imminent sets, in the minds of some, the stage for a dollar collapse.
But on the other hand, the Fed may not have finished raising rates yet. Thus, interest rate differentials interfere with the valuation of the dollar on the basis its fundamentals, and this has a knock on effect in the gold market.
Many who believe that the dollar and gold have decoupled are forgetting something basic and inescapable about the nature of financial markets; that things are realised and acted on by different groups of investors at different times. Thus while one group, composed, say, of many of those now piling into gold, may realise that the dollar is doomed, others may be sceptical of this line of reasoning. This being the way of things, the dollar and gold are unlikely to make their moves simultaneously.
Another factor is that arguably with every year that passes, the number of people holding the conviction that gold is an unshakable substitute currency, and something that deserves to be an ultimate store of value, decreases. Therefore, the number of people ready to invest in the metal at the slightest sign of dollar instability or heightening geopolitical risks to the world economy decreases also.
Some of those reluctant to trust their wealth to gold may be persuaded as others do so and the price of gold rises in response, but some will never subscribe, and some will instead move into alternative reserve currencies. The net effect is that lags and complications are introduced into the changes in the gold price that result from changes in the parity of the dollar.
All this of course presupposes that there should be a relationship between the value of gold and the value of the dollar. The dollar has for a long time now functioned as the world?s main reserve currency. It wasn?t always that way in the past, and it won?t always be that way in the future. Now is a period of transition; the dollar is unsteady on its feet, but the alternatives lack the kudos to step in fully as replacements. Therefore gold takes up a likely impermanent but currently indisputable position as a quasi currency.
There is also the likelihood that demand for gold for making jewellery and for use in industry has now entered a period of growth. China is the main force behind this, in gold as it is in other commodity markets, and underinvestment in gold projects in preceding years only adds to the effect. This supply versus demand imbalance in the gold market, existing at least until the host of new projects now in gestation at one stage or another come on stream, only adds to the bullish consensus for the metal. But it is probably a subsidiary factor.
Perhaps the best way of interpreting the whole gold price related melange is to underpin one?s holistic analysis with the assumption that the gold price will remain elevated by some proportion or another as long as the dollar remains unstable and no adequate alternative reserve currency is present.
But one must complement this by taking into account factors that may be temporarily more salient, such as the deranged words of Iran?s lunatic administration on this or that. Basic trends in demand and supply obviously have weight too. Plus, the overall analysis must be tempered by the reality that markets just don?t move neatly and exactly, but despite this, their essential direction remains unaltered and discernible.
Investors who want to call the fundamental top for the gold price, in other words that dictated by the underpinning factor just identified, should pay attention to where the dollar eventually settles, how long it takes people to get used to the currency?s new parity, and how quickly alternative reserve currencies move into the frame.
