August 2007

The dollar-gold relationship

By D. Zlotnikov

Despite the rising gold prices, some analysts are disappointed with the metal’s performance, saying the price jump did not meet their expectations. Bart Melek, global commodity strategist with BMO Capital Markets, sheds light on a few of the reasons for the (relatively) poor performance.

First and foremost, why are gold and the dollar tied in such a consistent inverse relationship? When the dollar drops in value, gold goes up, and when the dollar gets stronger, gold takes a nosedive, and so it has been for a very long time indeed.  “Gold,” said Melek, “has historically been the most convenient and accessible hedge against inflation. Gold has traditionally increased in value fast enough to at least keep up with inflation. When people, especially in developing countries where the financial systems aren’t as sophisticated, want to protect themselves against inflation, they buy gold.”

The dollar, and Melek clarifies (only half-jokingly) that despite popular belief, there’s only one “dollar,” is one of the world’s major trade currencies, and its value is a reflection of the world’s most powerful national economy. If investors around the world lose confidence in the stability of the dollar’s value when they are concerned about possible losses due to inflation, you’re bound to see a sudden interest in anything that can provide security against inflation, which is where gold comes in.

The above suggests then that gold prices remained lower than expected because the dollar did better than the investors anticipated. That is, in fact, exactly what happened, says Melek. One reason for this turn of events is that the collapse of the US housing market did not hurt the rest of the economy as much as anticipated, at least not yet. Real estate, representing a major portion of the US economy, has spread its misfortune far and wide and had an overall slowing effect on US inflation, but not enough to convince the Feds to lower rates. The Federal Reserve was expected to ease interest rates in an attempt to offset slower housing, but instead it is expected to keep them at the current level. For the time being, the dollar’s value has stabilized, and even recovered some.  The investors, in turn, slowed their rush to sell off the dollar, and investor demand for gold has predictably dropped off.

In a related event, the European central bank has sold off some of its gold stockpile, most likely in a deliberate attempt to restrain the increase in gold prices. The Washington Agreement, of which most central banks are signatories, restricts the sale of gold stockpiles to 500 tons per year, a point the European Central Bank system has already reached, effectively putting an end to that sell-off.  But despite the massive injection of gold supply into the market, the price is not in a freefall and Melek believes will be back on track for hitting the $700 mark before the end of the year.

On the mining side of the equation, we are continuing to see a slow decrease in mine production.  This decrease is primarily caused by the constantly decreasing grade of the available reserves, but ongoing shortages are also exacerbating the problem.  Shortfalls are making themselves felt in every area from skilled labour to drills to the most basic consumables such as truck tires and even cement. While not directly affecting the market price of gold, these shortages serve to increase the cash costs of production, pushing borderline projects into the red, and decreasing the flow of the metal to the markets.

On a larger, longer-term scale, Melek points out that despite the current recovery, the dollar is still not doing well. “Since 2002, we’ve seen the dollar drop about 30 per cent,” he says, a very significant decrease. And according to Melek, the dollar has a ways to go yet before it begins to recover. The European Central Bank, Melek says, will continue to set its interest rates higher, continuing to make the Euro more attractive an investment than the US dollar. The US trade deficit, already large and still growing, will have to be addressed before any recovery of the dollar’s value will occur. Finally, somewhat of a wild card, China might give in to the pressure, and set its interest rates and currency value to reflect its actual economic state. With its strong growth, Chinese currency is likely to prove an attractive purchase, once again undermining the value of the dollar. And gold, in turn, having already hit a 26-year high, will keep going up. Will it get to new, previously unseen highs? That, as they say, is the million-dollar question.

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