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Kitco In Focus: Broad Dollar Index and USD Gold - A Brief Analysis
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Kitco In Focus1: Broad Dollar Index and USD Gold – A Brief Analysis
As I had mentioned last week, some of the volatility in the spot price of gold has been traditionally attributed to changes in the valuation of the US dollar. Since its peak on February 27th 2002, the dollar has fallen by nearly 23 percent2. In the past month alone, the dollar has fallen by 2.9 percent and much of gold’s gain has been attributed to this decline. The rationale is that gold is viewed as good protection against such depreciation. The underlying reasoning is similar to that on inflation except the loss in purchasing power, now, is external instead of internal3.
Saying that the price of gold is dependent on the valuation of the US dollar suggests that there should be a strong correlation between the US dollar exchange rate and the gold price. Over the long run, a comparison of the data on US dollar price of gold and the Broad Dollar Index, a measure of dollar value, confirms our rationale. The correlation between the US dollar price of gold and the Broad Dollar Index is -0.9075 between the years 2002 to 20074. That is, a rise in the US dollar price of gold is reliably coupled with a fall in the value of the dollar. It also implies that gold has good hedging properties5.
Gold and the Broad Dollar Index in 2007
The chart below gives us a bird’s eye view of this year’s performance of gold and the Broad Dollar Index. The data was taken from January 2nd to October 12th, 2007.
Inspecting the data reveals the following:
- The year begins with a strong dollar. The Broad Dollar Index gives its highest value of 107.99 in January while, in the same month, gold reaches its lowest value of the year at $608.40.
- The average price of gold is $669.46, with a standard deviation of $27.46.
- The average Broad Dollar Index is 104.6, with a standard deviation of 2.155.
- The present month of October reveals the lowest valuation of the dollar, 99.9078, on October 11th, and the highest price of gold, $748.50, on October 12th.
Given the above, it would seem as though we should always expect an inverse relationship between gold and the value of the US dollar; however, what may hold over the long run may not hold over the short. Consider the relationship between gold and the value of the dollar on a monthly basis. The chart below summarizes the relationship for each month of 2007.
It is clear from the above chart that the overall relationship between the US dollar price of gold and the value of the US dollar is negative; however, this relationship is not guaranteed to hold for all periods and the strength of the relationship varies from being very strong (i.e. closer to -1) to very weak (i.e. closer to 0). In some periods we may observe a de-coupling of the two variables from its expected relationship. That is, instead of observing a negative relationship we may observe a positive one. In this case, we might observe both a fall in both the price of gold and the value of the US dollar, just as we had in the month of May.
Here we have a de-coupling of the expected relationship between gold and the dollar. According to Jon Nadler, Kitco’s Senior Analyst and creator of our Kitcommentary, “the entree of institutional players has added volatility and counter-intuitive characteristics to the gold market. The bottom line for May was inherent weakness, fund liquidations on disappointment in prices and the closure of the May Indian buying period. Gold went dollar-independent for a while. What is normally carved in stone can also be thrown out as law when other circumstances take over and overshadow the expected correlation”. Of course, we have seen this kind of de-coupling before among other variables, which is why Broad Dollar Index data and the USDX are used predominately to confirm instead of predict a price change over the short run.
As for the month of October, the data reveals the ‘traditional’ relationship that is to be expected. The month started out with gold’s price falling by 2.3% along with an increase in the value of the dollar by less than a third of a percent. From October 4th to the 12th, gold has increased by 3.17% while the dollar has fallen by 0.6%.
In next week’s article, I will be incorporating trade data into the analysis to see what more can be learned.
Until then, take care and I wish you a really great week, Wendy
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1 The purpose of Kitco In Focus is to bring to our viewers a perspective regarding the precious metals market with the hope of shedding clarity on the complex nature of this market. At least initially, the aim for this series of articles is to pull out those relevant factors that play some role in the market and explain them each in turn so that we can gain a better understanding of key concepts introduced by various authors who have worked diligently within the precious metals industry.
It is in my hope that Kitco In Focus will also be inspired by our readers in terms of what they would like explained or the questions they would like to bring to the table. In regards to this, I am sure we all know that there are various ways to understand, explain, and analyze any given topic and that these various ways can be competing bodies of knowledge. I really want to be clear on this because there is no universal or agreed upon way of understanding all of those important and not so important factors that influence the precious metals market. I hope to bring most of these perspectives to the table, although not all at once or within one article, so that our readers can have a comprehensive understanding of the dialogue that exists within this industry. I want to stress that even in my attempts to do this, others may not share the perspective that is presented and that I think this is completely natural and healthy in any honest dialogue that exists on any given topic. We all want to arrive at the best understanding of the market we are all so very passionate about, myself included.
With this said, Kitco In Focus is written as a tribute to all of those who frequent our site and for those who would like a deeper understanding of those economic factors that are commonly assumed to play some role in our market.
2 The valuation of the US dollar was defined by the Broad Dollar Index. The index measures movements of the dollar against the currencies of 26 of the United States’ most significant trading partners.
3 For my discussion on inflation, please seeThe Consumer Price Index and Spot Price of Gold.
4 A correlation of -0.9075 implies a very strong and negative relationship between the two variables. We should expect this kind of result for variables that run countercyclical to each other. That is, a rise in the US dollar price of gold is coupled with a fall in the value of the dollar. It also implies that gold has good hedging properties.
5 Forest Capie, Terence C Mills, and Geoffrey Wood provide an in depth analysis of gold and exchange rates in their study Gold as a Hedge against the US Dollar, WGC Research Study No. 30 (September 2004).
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Copyright © 2007 Kitco Inc.
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