Gold and the U.S. Dollar. Two of the world's most sought-after assets. And with one rather complicated price connection.
The U.S. Dollar and Gold usually have an inverse relationship, meaning their prices move in opposite directions. As safe-haven assets (investopedia.com), they are both typically valued by investors during difficult economic and political times.
To better understand their correlation, it’s helpful to examine the numerous factors impacting the U.S. Dollar and Gold in different scenarios.
How does the inverse relationship function?
Most of the primary raw materials have their prices set in U.S. Dollars on the international markets. Gold is no exception.
Generally, when the Dollar price increases compared to other currencies, Gold tends to fall as it becomes more expensive to buy other currencies outside Dollars. On the other hand, when the Dollar's value drops, people tend to buy more Gold as it gets cheaper in different currencies. This is what we understand by an inverse correlation between both assets.
Additionally, Gold typically benefits from U.S. low-interest rates, and a declining interest rate environment. At the same time, currencies such as the Dollar are pressured by it.
If interest rates are falling, assets such as Gold become more appealing to investors than currencies. That’s because Gold is a non-yielding asset*. Conversely, if interest rates are rising, Gold loses ground, as investors move toward interest-yielding currencies. Now you can also understand why central banks announcements are so essential for the financial markets.
*Yield defines the earnings deriving from an investment during a specific timeframe.
However, things weren’t always like this.
Gold and the U.S. Dollar – the initial connection
From 1900 to 1971, people were using the Gold standard. During those times, the value of a unit of currency was tied to a specific amount of Gold. So, the precious metal and the U.S. Dollar were always moving in unison, until President Nixon's famous set of measures. Among these measures was "a unilateral cancellation of the United States Dollar's direct international convertibility to Gold.” (wikipedia.com). Following this decision, several things changed.
First, both Gold and the American currency started deriving their value from the supply and demand principle. Then, the U.S. Dollar turned into fiat currency and stopped being backed by any physical commodity. Additionally, it was included in the forex market, basically starting its existence as a traded currency from 1971. Lastly, the American officials decided to use the U.S. Dollar as a reserve currency.
Nowadays, more than 60% of all foreign bank reserves are kept in U.S. Dollars. 50% of the Gold price changes from 2002-2008 were directly connected to the U.S. Dollar (info from a report issued by the International Monetary Fund).
Gold and the U.S. Dollar ties – exceptions to the rule
There are times when Gold and the U.S. Dollar can still move in unison. Frequently, this might happen during a severe global crisis. As both assets are considered safe havens (investopedia.com), investors could be tempted to protect their funds by pouring money in.
That's what happened at the beginning of 2020, more specifically in January and February. Both Gold and the U.S. Dollar prices rose in price until the positive correlation reversed during the epic stocks’ selloff in March. Then, we started seeing the negative correlation taking over – Gold sold off while the U.S. Dollar rallied. As stocks began rebounding in late March, Gold followed higher while the Dollar resumed its downwards spiral.
There are many different elements to factor in when discussing the U.S. Dollar – Gold correlation. Generally, the two assets have an inverse relationship, with some exceptions. Still, investors should keep in mind that the U.S. Dollar can also be influenced by various other things, such as monetary policy decisions or inflation. Also, traders will continue to use Gold for hedging purposes against currencies devaluation, but also in times of economic uncertainty.
Sources: wikipedia.org, investopedia.com, thebalance.com
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