If you have been reading our research articles, you must have seen that our analysts very often talk about the negative correlation between gold and the US dollar. In general, when the value of the dollar rises in relation to other currencies, the price of gold tends to fall in US dollar terms. This is because gold becomes more expensive in other currencies. Since gold is traded in dollars, it is usually said that a weaker dollar makes gold cheaper for other countries, which increases their demand for gold, and which in turn drives up the price, giving gold and the dollar their negative relationship. In this article, we look at this traditional theory, while also examining gold’s role as an international traded currency.
Trade weighted value of the dollar
When we talk about the trade weighted value of the dollar, we usually refer to the measurement of the foreign exchange value of the US dollar when it is compared against certain foreign currencies. Trade-weighted dollars lend weight to currencies most broadly used in international trade. These currencies form a group of major US trading partners and include: the Euro Area, Canada, Japan, Mexico, China, United Kingdom, Taiwan, Korea, Singapore, Hong Kong, Malaysia, Brazil, Switzerland, Thailand, Philippines, Australia, Indonesia, India, Israel, Saudi Arabia, Russia, Sweden, Argentina, Venezuela, Chile and Colombia.
The trade-weighted value of the dollar creates an index showing whether the dollar is gaining or losing purchasing power on average against its trading partners.When it comes to gold, the yellow metal has a negative relationship to the trade-weighted value of the dollar.
This means that when other currencies gain value against the dollar, so is gold. In this sense, gold acts like other currencies, so when the dollar loses value against most currencies, then it also loses value against gold. This highlights their negative correlation and not a fundamental relationship where the value of the dollar influences the value of gold.
Gold as an internationally traded currency
For many analysts, the negative correlation between the USD and gold is not due to the fact that movements in the value of gold are usually expressed in dollars. Instead, it is because gold is an internationally traded currency. As Fergal O’Connor and Dr Brian Lucey show in their article, “Gold’s negative relationship with the US dollar,” “on average, the value of gold expressed in a currency (e.g. the pound) would move with the value of other currencies expressed relative to the pound, their bilateral exchange rate.
This would then give us a negative relationship between gold expressed in terms of pounds and the trade-weighted value of the pound. ”As they argue, “For most of the time, the correlation between the returns on gold expressed in a currency and the returns on the trade-weighted value of that currency is negative, over 90% of the time for each currency.”
In this respect, the returns on gold in a currency have a “negative relationship with the currency’s trade-weighted returns over short, medium and long horizons.” For them, this demonstrates that the negative relationship between gold and the value of the dollar underlines gold’s role “as an internationally traded currency, rather than a way of explaining movements in the value of gold expressed in dollars.”
US Interest Rates
Another factor that influences the price of gold is US interest rates. Since gold does not yield interest it must contest with interest-bearing assets for demand.According to precious metals analyst, Kirill Kirilenko, gold‘s price skyrocketed, between 1971 and mid-1974, and again between 1976 and 1980, when the Fed increased interest rates to respond to high inflation. Gold’s performance was almost a result of its perceived status as a hedge against inflation.Increasing US rates most often offers support to the dollar and weighs on the gold price denominated in US dollar terms.
However, declining rates elsewhere could potentially make gold more attractive to both investors and consumers.There is also a psychological aspect to the value of gold, as during times of uncertainty or geopolitical turmoil, the price of the metal tends to rise as faith in governments wanes.
On the other hand, during peaceful times, the price of gold tends to fall.Nonetheless, gold retains its negative correlation to the US dollar, for the several factors outlined above, but most importantly as it is an international traded currency.
