From 1900 to 1971, the world relied on the gold standard to determine the value of a currency. During this period, a currency unit’s price was tied to a particular amount of gold. In 1971, the gold standard was withdrawn, and both gold and the US dollar were freed. Their values could now be determined on basis of market supply and demand.
The US began to be used as a global reserve currency, and it traded on foreign markets. At the same time, gold switched over to floating exchange rates. This created a relationship between the price of gold and the US dollar’s external value. According to the IMF estimates, nearly half of the movements in gold prices between 2002 and 2008 were dollar related. When the effective external value of the dollar changed by one percent, it resulted in more than one percent change in the price of gold.
Historical price data reveals that an inverse relationship exists between the price of gold and the trade-weighted dollar. Trade-weighted value of dollar indicates how the dollar is losing or gaining purchasing power in comparison to its trading partners. Two key reasons behind the continuing inverse relationship between gold and dollar are as follows:
- A decrease in the value of dollar leads to an increase in the value of currencies of other countries. This propels the demand for globally traded commodities, including gold. The increase in demand results in the increase in prices.
- Whenever the dollar begins to lose its value due to economic or political factors, investors around the world tend to look for alternative sources of investment in order to store value. Gold becomes a trusted and time-tested alternative store of value in such conditions.
However, investors should understand that in some situations, the prices of gold and the US dollar can increase simultaneously. This may happen when a crisis happens in another region of the world, prompting investors to rush to safer havens – the US dollar and gold.
Preference for Gold in Uncertain Times
The US dollar became more prone to fluctuations as it was freed from the gold standard. These dollar fluctuations can be heightened during the times of economic, social or political uncertainty. In such a situation, gold becomes a safe harbor for investors, who want to use it as a hedge against economic recession and inflationary pressures.
In comparison to international currencies, the value of gold remains relatively stable. However, its price can fluctuate in any given currency once the perceived value of that currency undergoes a change. Its price fluctuations in US dollar indicate the confidence in the currency, as the dollar adjusts its value in relation to gold.
Therefore, the gold prices tend to move in a direction opposite to the value of the dollar. An investor must be able to recognize the subtleties of the dollar-gold inverse relationship and appreciate their historical inverse movements. This can help them predict the periods when the inverse correlation is most likely to be set off, and how they can leverage it to their advantage when investing.
Degree of Confidence in US Dollar
The historical relationship between the dollar and gold continues to hold a psychological sway over investors globally and influences the policies of leading international banking institutions. Whenever the US dollar appears to be losing its sheen in the currency market, investors as well as the international banks holding dollar reserves tend to abandon the dollar in favor of gold.
The converse of this phenomenon also holds true. When the US dollar is getting stronger, the investors and global banks will tend to switch their reserves from gold to dollar. This causes a spike in the value of dollar in relation to gold. Currency and commodity traders and investors around the world have traditionally relied on this inverse relationship between gold and dollar to place their money bets.
However, the inverse relationship between gold and dollar is subtle and complex. Investors should try to take a balanced view between the historical price movements and the current conditions to determine which type of situation will trigger the instinct to bring the inverse relationship into play, thus opening safe and attractive opportunities for investment.