Investors of gold and currency traders may want to familiarize themselves with the relationship of gold to the U.S. dollar and other currencies. Because the U.S. dollar is unbacked by gold and other commodities and is backed only by confidence — a psychological element — the U.S. dollar may have significant swings relative to gold, and these swings deserve great scrutiny to find patterns or correlations. Thus, it is worth looking at the relationship between gold and the trade-weighted dollar index as well as the U.S. dollar index (DXY).
Gold Is Rare
Unlike the U.S. dollar, gold is a rare and finite resource that cannot be printed at whim. Global production is fairly steady, increasing the amount of global gold stocks by one to two percent each year. Unlike silver, which is largely used in industry and discarded into landfills, gold is generally stored in bank vaults and worn as jewelry, thus keeping the majority of the yellow metal that has been mined historically above-ground and ready for investment or personal use. Gold is universally recognized as a form of money precisely because of its rarity and difficulty in extracting it from the Earth’s crust: mining gold requires enormous amounts of investment due to the energy and labor required.
Gold vs. Trade Weighted-Dollar Index
Because of the psychological nature of the value of the U.S. dollar, particularly in relation to gold, which is much more fixed in quantity, one way to look at the relationship is to see gold and not the U.S. dollar as a point of reference or numeraire, contrary to how the relationship is typically viewed by economists and financial pundits. Numeraire is a French term used in mathematics that means the standard by which value is computed. Using gold as the numeraire, the value of gold can be seen as constant and the U.S. dollar’s value as fluctuating relative to this constant. Jim Rickards, a widely-respected gold analyst, has popularized this way of looking at gold.
Thus, the value of gold in U.S. dollars can be seen not so much as a reflection of the volatility of gold but rather of the U.S. dollar: when the price of gold goes up, it means that the value of the U.S. dollar has declined, and when the price of gold goes down, it means that the value of the U.S. dollar has increased. As of July 2016, global confidence in the U.S. dollar is strong due to its reserve currency status and relatively robust economy. A strong U.S. dollar necessarily will suppress the price of gold to some degree, hence gold’s roughly 25 percent discount right now compared to its all-time high of about $1,900.
The correlation between the price of gold and the trade-weighted index, an index created by the Federal Reserve measuring the value of gold relative to 26 other currencies, is weakened by the fact that the index uses fiat currencies — currencies that are unbacked by gold or other commodities — that have absolutely no peg to gold. These fiat currencies can also, as a group, depreciate in value relative to gold yet still maintain the same numerical value relative to one another, because these currencies can be devalued by printing them via computer keystrokes, whereas gold cannot be created in this manner. However, as the trade-weighted dollar index chart above shows, there is a correlation, though not perfect, between the movement of the value of the U.S. dollar and the movement in the price of gold. For example, when the U.S. dollar bottomed in or around April of 2011 at under 70 relative to other currencies, gold hit a new all-time high in U.S. dollars.
Similarly, the correlation between the U.S. dollar and the widely-used U.S. dollar index (DXY) — an index measuring the value of the U.S. dollar relative to six major currencies — is weakened due to the psychological nature of the value of fiat currencies, especially in relation to one another. However, as a general rule, the price of gold in U.S. dollars will tend to rise when the U.S. dollar index moves down, and conversely the price of gold will decline when the U.S. dollar index moves up.
This relationship between gold and the U.S. dollar, while not perfect, should be taken into account by investors to better grasp the forces driving the gold price.